Benefiting from market selloffs: A Low-Cost, Low-Risk Bear Market Trade

In hindsight, we all know it was a good idea to short internet stocks in the first quarter of 2000. Shorting a stock involves selling it without owning it. You borrow shares from your broker. Eventually you’ll need to buy the shares to repay the loan. If the price drops before then, you are buying at a lower price than you sold at and you earn a profit. The idea of short selling is essentially the same as with any other trade. You want to buy low and sell high. With short selling, the selling comes first.

4Short sellers can make a lot of money in bear markets and many investors noticed the internet bubble seemed destined to end in a bear market. Super Bowl viewers in 2000 could tell the market was in a bubble when the sock puppet mascot of Pets.com appeared in a $2 million commercial. Pets.com had an unsustainable business model – sell 50-pound bags of dog food cheaper than anyone else and throw in free delivery. They lost money on every order and somehow planned to become a market leader.

Now we know you can’t lose money for an extended period of time unless your business plan clearly defines how the business will turn around. There was no strategy for Pets.com or dozens of other companies whose stock price went up on hope rather than earnings potential.

At the time, many investors knew the bubble couldn’t last. But they also knew, as the economist John Maynard Keynes had pointed out many years before, “the market can stay irrational longer than you can stay solvent.”  Prices eventually did fall, but only after rising more than rational investors expected.

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During the internet bubbles, many short sellers suffered large losses and ended up closing their positions at a loss. Ultimately they were right but they didn’t enjoy a profit because they were early. Timing is especially important for short sellers because of the risks involved.

When you short a stock, you are accepting unlimited risk. If the stock price goes up in price you suffer a loss. It’s possible the loss will become too large to bear and you’ll be forced to cover the short position at a loss. There is also the risk that your broker will demand that you repay the shares you borrowed at any time. This is known as a “short squeeze” and can result in an immediate loss. Or, the cost of carrying the loan can rise suddenly and become unaffordable. Remember that a short sale involves a loan and all loans carry interest. In the case of a short sale, the interest rate is variable and it can rise sharply based on market condition. It’s possible you could be right that the stock will fall, but still lose money on the trade if the cost of the loan becomes too high.

Those risks make shorting too dangerous for many individual investors. But Wall Street firms understand the appeal of trading on the short side and created ETFs that can benefit from market declines with limited risk. These funds trade like stocks and are available to individual investors.  Inverse ETFs increase in value when prices fall. Risks of owning any ETF are limited to the price you pay so you can never lose more than you invest in an inverse ETF. But, inverse ETFs have a unique problem that can hurt investors even in a declining market. Inverse ETFs rebalance their portfolios daily. They are designed to track market changes for one day at a time and this can lead to losses even if the trend is down.

The math of inverse funds can be confusing but the important point is that whenever a negative return is compounded, its impact will be larger than the compounding of a positive return of the same magnitude. Let’s look at a simple example.

Assume you start with a fund priced at $10. It gains 10% the first day and the fund soars to $11 in value. It then loses 10% the next day and the fund declines to $9.90. The impact of a loss will always be greater than the impact of an equal-sized gain when returns are calculated this way. In volatile markets, inverse funds quickly deviate from the long-term trend as the impact of daily price changes compound.

The problem is worse for leveraged inverse funds. Inverse and leveraged ETFs are actually designed for short-term trading, as their prospectuses clearly note. Results are often disappointing over the long term as tracking error reduces gains or even turns expected gains into losses.

There is an investment that can benefit from a market decline without the drawbacks of short selling or inverse ETFs. Put options increase in value when prices fall and have limited risks. Puts also generally sell at low prices.

A put option gives the buyer the right, but not the obligation, to sell shares of a stock at a predetermined price for a specified amount of time. The risk is limited to the amount paid for the put.

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For example, consider a stock trading at $100 a share. You believe this stock is overbought and likely to fall by 15% in the next six months. You can buy a put option with an exercise price of $100 that expires in six months for $3. The exercise price is the price you can sell the stock for during the term of the contract. The contract covers 100 shares and would cost $300 ($3 * 100 shares).

If the stock trades in line with your expectations, it falls to $85. The put option would be worth at least $15, the difference between what you could exercise the option for ($100) and the market price ($85). You wouldn’t have to exercise the option because the market price of the put will adapt to changes in the stock price. You could simply sell the option for $15 and capture a gain of $12 per share or $1,200 per contract. This is a 300% return on investment. If you had shorted the stock, your gain would have $15 per share less commissions and interest. An inverse ETF would deliver a gain or loss depending upon the sequence of daily changes. A put option potentially offers the least expensive and surest way to benefit from a decline.

If you were wrong and the stock declined just 10% to $90, the put option would be worth at least $10 and you would make $700 on the trade. You would have a gain in the option at any stock price below $97. If the stock was above $97 but less than $100 your loss would be less than $3. If the stock trades above $100, your loss would be limited to $3 per share or $300 per contract.

You’ll notice that the value of the option is worth “at least” the difference between the option’s exercise price and the market value of the stock. There are a number of factors involved in options prices and the put could be worth more than that difference at times. Options are complex mathematically but from an investor’s perspective they are relatively simple to understand – put options allow you to benefit from market declines with limited risk and provide a large potential upside. They typically cost just a few dollars and could be used in small accounts.  In fact, put options might be the best way for small investors to benefit from expected market declines.

Hopefully with this article you see that puts can be a valuable addition to your trading toolbox. There are other uses for put options that we review in different articles.