There are lots of ways to make money from a falling stock market, some speculative, and some not so risky. And it is a good thing too, because small investors need a way to protect themselves, and even make money on the downside. Hopefully, the stock market is near the bottom, but if it has a long way to go before it finishes dropping, then here are several options to choose from.
1. Shorting Stocks
OK, let's get this one over with first because it is one of the most speculative ways of making money in a bear market. In simple terms, you make money when the stock goes down and you lose money when the stock goes up. What technically happens is that you borrow the shares and immediately sell them (this all is done electronically through your brokerage firm) and since you owe those shares, you eventually have to buy them back at some price, hopefully a lower price. The difference between your sale price and eventual purchase price is your profit.
Can you make a lot of money shorting stocks in a bear market? Yes. Is it speculative? Very. Can you lose a lot? Most definitely. This is why it is so risky. When you short a stock, the lowest point it can drop to is zero. Whereas, if the stock goes up, the amount it can rise is unlimited. Let's say you short 100 shares of a stock at $20 a share. If you put up funds equal to 100% of the value of the shorted amount, and the stock drops to zero, you've made a 100% return. However, suppose the stock goes from 20 to 100, you end up losing 400% of your money with lots of margin calls along the way.
Have I shorted stocks? Yes. Have I made money from shorting? Yes, especially during the last few months. Have I lost a big chunk of my profits by closing out my short positions and going long, trying to predict the bottom a few weeks ago? In the interest of full disclosure, yes. I made the second worse decision I could have made when shorting, and that is predicting the bottom of the market too soon. The worst decision would have been to hold on to my short positions after the market bottoms and starts to make a quick rise. Often when the market bottoms at the end of a bear market, the rise is very sharp and fast, and can totally wipe out short position profits very quickly and then some.
But even on a short term basis, an investor can lose money very fast. A friend of mine, who is a trader, told me that he does a lot of shorting but always hedges his shorts by buying calls to protect himself in case the stock moves up. When I told him that I never hedge my individual stock shorts, he said "You're kidding! I never give advice to anyone, but I'm going to give you some advice. Never short a stock without hedging. You might be watching the market, then get up and go to the bathroom, come back a half hour later and discover that you've been wiped out!"
Even though my bathroom breaks are not that long, he does have a good point. A few months ago, shortly after I shorted a high stock price real estate investment trust, the position went against me by 13 points. That's a $1,300 loss for every hundred shares in one day! I still had the short position after the market closed, and had the pleasure of trying to sleep at night, wondering if there was going to be a takeover the next morning or some other good news that would drive the price even higher, making my losses worse.
So in summery, do I think you should short stocks? Absolutely not. The risk is unbelievable. If you understand options real well, hedged short selling might be OK, as long as you are an advanced trader, and know what you're doing.
2. Short (Bearish) ETFs
A new financial animal appeared on the scene a few years ago, a type of Exchange Traded Fund called the Bearish ETF or Short ETF. What these ETFs do is provide a return opposite to the return of the index, sector or industry that it is tracking.
A list of 15 bearish ETFs can be found at WallStreetNewsNetwork.com. For example, the Short Dow30 ProShares (DOG) provides a return that is the inverse of the Dow Jones Industrial Average. If the Dow goes down 2%, the DOG goes up 2%. The Short QQQ ProShares (PSQ) ETF gives a return that is the inverse of the NASDAQ 100 Index. If you are bearish on gold, you can buy the PowerShares DB Gold Short ETN (BGZ) ETF.
The nice thing about these short ETFs is that your losses are limited. Also, if you are long individual stocks that you don't want to sell, these can be good for protecting your portfolio on the downside.
3. Leveraged Bearish ETFs
If you like volatility, you will love the leveraged bearish ETFs. What these ETFs do is provide double, and in some cases triple the inverse return of indices. WallStreetNewsNetwork.com has a list of 40 leveraged bearish ETFs, such as the UltraShort Telecommunications ProShares (TLL), the Rydex Inverse 2x S&P Select Sector Health (RHO), the UltraShort Consumer Services ProShares (SCC) and the Rydex Inverse 2x S&P Select Sector Tech (RTW).
In addition there are four triple leveraged bearish ETFs. Talk about price moves! The volatility of these things is unbelievable, and so are the wide bid and asked spreads that I've seen occasionally.
The advantage of these trading vehicles is that they are a way of shorting on margin, with a limit on the downside. The disadvantage is that the losses are quick and large, especially with the triple leverage short ETFs.
4. Bear Funds
It may be hard to believe, but there are actually a large number of bearish mutual funds for the long term bearish investors. WallStreetNewsNetwork.com came up with 30 bear funds, including the Grizzly Short Fund (GRZZX), the PIMCO StocksPlus TR Short Strategy Institutional Fund (PSTIX), and the ProFunds Bear Investors Fund (BRPIX). These funds have minimum investments ranging from $1,000 to $5,000,000.
I'm not sure why anyone would invest in these unless it is for some kind of a long term hedge, and these days, who's investing long term?
A put is the option to put your stock to someone at a particular price within a certain period of time. In other words, if you own a stock that is trading at 22 and you buy a put at a dollar [puts and calls are priced on a per share basis, so a put at $1 would cost $100 for 100 shares] which gives you the right to put your stock to someone at $20 per share within three months, there are a couple of things that could happen. The stock could tank to $14 a share and you could put your stock at 20, or just resell the put for 6. You would be far better off than just doing nothing. And if the stock goes up or stays about the same, you are just out your $100 for the option. Puts can be useful for experienced traders.
There is one other way to make money in a bear market. Sell everything, and keep your money in cash, preferably a T-bill money market fund, that only owns T-bills. (Repos are supposed to be just as safe, but these days, I would look for the ones that just own the T-bills.) The advantages are that you can't lose money and you can receive an income from the investment.
I've been putting off writing this article because I kept thinking that we were so close to the market bottom that making money in a bear market would be a moot point, yet the market kept on dropping. Maybe now that I've published this article, it will really be the market bottom, and you can save this article for the next bear market in six or seven years.
Author does not own any of the above mentioned securities.