Not everyone loses when the stock market goes down
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People invest their money into the stock market hoping to see their money appreciate. Sometimes that money appreciation happens immediately, but most of the time appreciation is seen over the long-term, and small 1–2% increases that feel unnoticeable now can become quite noticeable in a few months if your portfolio has an upward trend.
Most people invest in the stock market through stock purchases. They buy some shares of their favorite companies and hold onto them for a certain amount of time. Some people sell at the wrong time, others hold the wrong companies, and other people hold onto the right companies that continue to experience growth.
Along the way, there will be turbulence. Your investments will decrease in value on certain days, and you might even have a week long losing streak. It happens.
But what if you could mitigate the downside and even make a profit when the stock market goes down? This is actually possible by betting against stocks.
The three common ways to bet against stocks are to short a stock, buy puts, and sell a covered call if you already own 100 shares of the stock. Shorting stocks and trading options are riskier investing strategies if you don’t know what you’re doing, so I’ll shed some light on both strategies.
When you short a stock, you essentially borrow shares of a company and proceed to sell those shares. You get the proceeds from that sale which you can divert to other investments, but you sold shares that don’t belong to you.
Eventually, you will have to buy those shares again to close out the short position. If you short a stock that’s currently priced at $100, and you buy it a few weeks later at $80, you make $20. In between that timeframe, you could have invested the $100 any way you pleased.
However, if the stock you short at $100 and it rose up to $200, you’d have to pay $200 to buy the share to close out your short position, and nothing is stopping the stock from reaching $300 and beyond, thus increasing your losses.
I personally don’t short stocks in this way because it opens the doors to unlimited losses. For the brave investors who want to give this a try, you can cap your losses through the purchase of a corresponding call.
Let’s say you short 100 shares of a stock currently priced at $50. You use some of your proceeds to buy a 55 strike call which gives you the ability to sell your 100 shares at $55/share within 3 months (let’s say for this example you paid $200 in premium, or $2/share).
This call will save you big time if the stock rises up to $100/share. That way, rather than repurchasing the shares at $100/share, you can buy 100 shares at $55/share because of your call option. The worst case scenario is a loss of $700 rather than unlimited losses.
However, the call will also bite into your profit. If you buy back the shares at $40/share, you don’t make a profit of $10/share even though you shorted the stock at $50/share.
You also have to account for the $200 premium, or $2/share which would cut your total profit to $8/share.
The other two ways to bet against a stock are less risky. Buying puts can produce exponential returns if you get the timing right, but if you get the timing long, you can lose your entire investment (some options expire worthless).
You can buy a protective put on one of your existing positions to protect yourself from short-term downside. This is a much better alternative than selling the shares out of fear.
I once sold off my Shopify shares way too early because I thought it was overvalued and never found a good re-entry price. Anytime I feel that way about a stock in my portfolio, I now buy a protective put instead of selling the shares. I rarely buy puts with this strategy, but it’s helped me remain a long-term investor for stocks that many articles have critiqued as being overvalued.
If you’re susceptible to panic selling, buying the protective put makes more sense than selling your shares if you believe in the company’s long-term outlook.
Buying puts is also a great approach to short stocks without taking on the risk of unlimited losses (the worst case is that the put’s value goes down to $0).
For instance, Nikola Motors is a fraudulent company that happens to be riding the EV waves where pre-revenue and conceptual businesses can be marketed as legitimate business enterprises that will be the future of our society (it also rode the SPAC wave, but that’s a topic for another time).
Since puts are a form of leverage, you don’t need to invest much into puts for them to have an impact on your portfolio. As a rule of thumb, I never invest more than 1% of my portfolio into puts. However, anytime the value of a put doubles or gets cut in half, it makes a big difference in how my portfolio performs that day.
The third way to short stocks is by selling covered calls. If you own 100 shares of a stock, you can sell a covered call where you agree to sell your shares if the stock hits a certain price.
Let’s say you have 100 shares of a company currently priced at $150. You sell a covered call with a 160 strike price that expires in 2 weeks, and this lands you a $300 premium.
If the stock fails to reach $160/share, the option will expire worthless and you keep the $300. If the stock rises beyond $160, you are forced to sell your shares at $160…even if the stock rises to $170.
Covered calls cap your upside for a set period of time in exchange for the premium. Some people sell covered calls on positions they want to get out of. That way, they keep collecting premiums until their shares get assigned at a desirable strike price.
Betting against stocks can pay off, but you’ll find yourself paying attention to the stock price more often. You’ll refresh your screen hoping to see the stock price decline.
Taking on a short position or a far out put with the long-term in mind will decrease the odds of you refreshing your screen, but most people who bet against stocks are more involved in the market.
The gains can be well worth the extra time, but make sure you don’t get distracted from building up your income and contributing to your portfolio each month.
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Should You Bet Against A Stock At Some Point? was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.
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