Betting against a stock and profiting when the price falls is possible thanks to a technique known as short selling, here’s how it works:
- Borrow the stock from your broker (this will have a cost based on how hard the stock is to borrow)
- Sell it immediately at the current market price
- Buy it again when the price is cheaper
- Return the borrowed stock
- After returning the borrowed stock if you bought it back cheaper than when you sold it then your profit is that price difference minus the associated costs.
This is the logic behind short selling and we’re sure that the moment you read these points there are thousands of questions flowing through your head such as:
- How can I find stocks to borrow?
- Who in his right mind would lend me stocks if they know that I’ll return them being worth less?
- What happens if instead of falling the stock price goes up?
All of this questions will make sense as we move on through our guide. What we explained is the basic notion of short selling, but in reality behind closed doors many different things could be happening depending on the broker and the assets that you’re trading with.
Short-selling is the easiest way to make a negative bet on a stock. It’s the logical opposite of buying low and selling high, in the traditional order. Instead, you’re borrowing shares to sell them at a high price, hoping to buy at a lower price later on and then returning the borrowed stock. Sell high and buy low, not the other way around.
Yes, this means selling shares you don’t actually own.
Because you’re borrowing shares to make this negative bet, the process includes a few wrinkles that don’t appear in the normal process of buying shares directly.
- Your accounts needs to be approved for margin trading, and any short-sale balances will count against whatever borrowing limits your stock broker has set up for your account. Since margin trading doesn’t go together with retirement accounts, short-selling is not going to be available in your IRA account. It’s a strategy strictly reserved for your taxable trading accounts.
- The margin trade adds its own set of risks. First, you broker will charge you interest on the borrowed funds, cutting into whatever returns your short-selling trades might produce. But that’s just the beginning. The Financial Industry Regulatory Authority sets regulatory limits on how much equity your account must hold to support your margin balances. Brokers often raise these limits on their own to cut their lending risks. If your equity at any time falls below those limits, you’ll be forced to come up with more funds or reduce your borrowed funds balances. This could happen in a hurry if your shorted stocks suddenly skyrocket. The resulting short-squeeze on a stock with very large short-selling interests can be powerful enough to drive share prices even higher as many of your fellow investors get caught in the same trap.
- Someone, somewhere actually does own your shorted shares. The lender — typically your online stock broker — could close out your borrowing contract at any time, forcing you to buy back the shares you sold earlier and return that stock position to the original holder. If your shorted stock is trading higher than your original short-sale price at the time, you’ll have to eat that loss.
- Shorting a generous dividend payer will force you to cough up those dividends out of your own pocket to reimburse the share lender. Don’t forget that you already sold those shares to someone else, who is collecting the actual dividends from the company. So this will be fresh cash from your wallet to the share lender’s, and nobody has to reimburse short sellers for these expenses.
Between the risks of forced buybacks and short squeezes, the obligation to cover dividend payments, the limited upside and unlimited downside to short-selling bets, and the many downsides to trading stocks in margin accounts, I totally understand if you don’t want to sell anything short now.
What Is Betting Against the Market?
Betting against the market means investing in a way that you’ll earn money if the stock market, or a specific security, loses value. It’s the opposite of buying shares in a security, which in effect is a bet that the security will gain value.
Short selling is one of the most common ways to bet against a stock. To short sell a stock, you borrow shares from someone and sell those shares immediately, with the promise that you’ll return the shares to the person you borrowed them from at a future date.
If the price of the shares falls between the time you sold them and the date you have to return those shares, you can buy the shares back at a lower price and keep the difference. If the price rises, you’ll have to pay extra out of pocket, losing money.
There are many other ways to bet against the market, some more complicated than others. These are some of the most common options.
Buy an Inverse Fund or Bear Fund
Some mutual funds and ETFs advertise themselves as inverse funds or bear funds. These funds work like any other mutual fund, letting individual investors buy shares, and tasking the fund managers with building and maintaining the portfolio.
But the goal of a bear fund is to gain value when the market drops. Typically, fund managers do this using derivatives like swaps. If you buy a Standard & Poor’s 500 bear fund and the S&P 500 loses 10% of its value, the bear fund should gain about 10%.
These funds tend to be one of the less risky ways to bet against the market because they are not overly complex and don’t involve leverage.
One thing to keep in mind, though, is that these funds tend to be more expensive to operate than more typical funds that hold shares in businesses. This is because of the additional costs and management associated with the derivatives that are required to produce a positive return in a downward market. Also recall that historically, the market tends to rise over time, meaning you won’t want to hold these funds for the long
Buying a Put
A put is an option that gives the holder the right, but not the obligation, to sell shares in a security at a set price (called the strike price) at any time before the expiration date. For example, you might buy a put that gives you the right to sell shares in XYZ at $35 any time between the day you purchase it and June 30.
In the example above, if the price of XYZ stock falls below $35, you can exercise the option and earn a profit. You’ll buy shares on the open market at the current market value, then sell them for $35 each.
Most options are for 100 shares, so the formula for calculating your profit from buying a put is:
((Strike Price – Market Price) * 100) – Premium Paid = Profit
So, if you paid a premium of $65 for the option and shares fall in value to $30, you’d earn:
(($35 – $30) * 100) – $65 = $435
Buying puts is betting against the market because they become more valuable as the price of the share falls farther below the strike price of the option.
Futures are a related concept. Futures contracts obligate two parties to conduct a transaction at a specified date in the future. This is in contrast to options, which are optional to exercise.
You can bet against the market with futures by signing a contract agreeing to sell a security below its current value. If it falls below the strike price of the contract when the future is exercised, you’ll turn a profit.
Short Sell an ETF
ETFs are like mutual funds in that they are investment vehicles that own shares in dozens or hundreds of other securities. They let investors buy shares in a single security, the ETF, to quickly and easily build a diversified portfolio.
There are ETFs focused on specific market indexes, the market as a whole, or individual industries. You can short sell ETFs to bet against specific sectors or the market as a whole. To do this, you’ll want to short sell an index ETF or an ETF focused on a specific index.
The drawback is that short selling has potentially infinite risk, as the price of the ETF can rise infinitely, in theory. Some ETFs also don’t have sufficient liquidity available to make short selling effective, so you’ll want to choose a popular ETF when short selling.
What Is the Best ETF to Short the Market?
There are many different ETFs that let you short the stock market. One of the most popular is the Pro Shares Short S&P 500 ETF, which “seeks a return that is -1x the return of its underlying benchmark.” Meaning, if the S&P loses 1% of its value, this fund aims to gain 1%.2
What Is the Best Way to Short the Market?
There is no single best way to short the market. Which strategy you prefer will depend on your investment goals and risk tolerance. For example, bear ETFs are simple to use, which makes them popular. However, short selling or using derivatives instead can let you leverage your portfolio, increasing your risk but also increasing potential rewards.
Is Buying a Put the Same as Shorting?
Buying a put is one of the many ways to bet against a stock or other security. Sometimes, betting against a security is colloquially referred to as “shorting” it. However, buying a put is different from a short sale, another way to bet against a stock. Short selling involves selling shares you do not own by borrowing them from someone and intending to buy those shares later to return them to your lender.