Calling the top of an uptrend can be tricky even for professional traders. But if you’re convinced the next bear phase is just around the corner or that the market is just about to complete a bearish correction, you can bet on falling prices by shorting the market.
There are a few methods to benefit in a bear market, even in the long run.
Whether by short-selling stock or entire stock groups, buying inverse ETFs or investing in asset classes that tend to outperform when the stock market enters a downtrend, you don’t have to stay at the sidelines when markets are about to crash.
What is Short Selling?
Short selling allows traders to profit in times of bear markets and falling prices. Traders often use short-selling to speculate on markets, but it can also be used to hedge against losses of a long position in the same security.
Short-selling is often considered riskier than simply taking a long position because of the possibility of infinite losses. When you buy a stock, the only amount you can lose if the company ceases business and the stock plunges to $0 is your initial investment, while the potential profits can be multiple times higher if the stock skyrockets.
When short-selling, the story is a little different. In the most optimistic scenario, you can double your initial investment if the stock falls to zero (without using leverage.) However, if the price starts to rise, you can lose much more than the amount you’ve invested.
In short-selling, a trader borrows a stock that has downside potential. The trader then sells the borrowed securities at the current market price, waits until the price drops, buys the securities at the current lower price and returns the borrowed securities to his broker.
Most brokers require a margin account to short-sell the market. In addition, a trader needs to pay financing costs on the borrowed securities to the broker for each day the short-position stays open.
Pros and Cons of Short Selling
Just like when buying stocks, short-selling can generate losses if the trader wrongly anticipates future market conditions. In addition, as noted earlier, short selling can theoretically lead to infinite losses if the stock price skyrockets.
Here’re the main pros and cons of short selling.
- Leverage – Short-selling can return high profits if the trader’s guess on falling prices proves to be correct. And with the help of leverage, those profits can be extremely high.
- Hedging – Short-selling can be used to hedge against falling prices in a long position.
- Infinite losses – If your analysis proves wrong and a stock’s bull run continues to the upside, you can face very high losses. Theoretically, those losses can be infinite since a stock’s price can rise to the infinity, but only fall to $0.
- Margin and interest – To short-sell in the market, you’ll need to open a margin account with your broker and pay financing costs on short positions.
When Should You Short the Market?
In a bear market, stock prices usually fall much faster than they rise during bull markets. This makes the timing very important if you want to short the market. If you short-sell too early, chances are that the price reverses which can lead to large losses. Conversely, short-selling too late can lead to a lower profit margin.
Here’s how to time your short position to take the most advantage of a bear market in the long-term:
Charts Show a Trend Reversal – Markets can move in long-lasting trends. Uptrends form higher highs and higher lows, while downtrends form lower lows and lower highs in the price-chart. A bearish trend reversal occurs when the price creates a lower low after a previous higher high, signalling a broken support level and the possibility of further weakness in the market.
Reversal chart patterns, such as double and triple tops, bearish wedges, and bearish head and shoulders patterns can be used to enter with a short position.
Technical Indicators Turn Bearish – Besides chart patterns, many technical traders also use technical indicators to confirm a new bearish trend. Trend-following indicators, such as the Average Directional Movement Index (ADX) or Moving Averages are popular choices to confirm a downtrend.
The ADX indicator includes three lines – the +DI line, the –DI line, and the ADX line. When the –DI line crosses above the +DI line and the ADX shows a reading of above 50, this signals a strong downtrend and a short-sell opportunity. Similarly, a falling slope of a 50-day or 100-day Moving Average can often indicate a downtrend.
Market Fundamentals Turn Bearish – Besides technical levels, traders can also use market fundamentals to determine the best time to short-sell the market in the long-term. Recessions often lead to long-lasting declines in stock prices. A recession occurs when the GDP shows negative growth for two consecutive quarters.
Company fundamentals, such as falling earnings, increasing inventory, and low investments, can also signal lower demand in the market and an upcoming downtrend.
How to Short in the Long Run?
So far, we’ve talked about trading bear markets by taking a short position in the underlying security.
However, there are also other cost-effective ways to take advantage of falling prices in the long run, such as buying put options, inverse ETFs, or through investments in other asset classes that are negatively correlated with the primary market that you want to short.
Shorting with Put Options
Put options are a very popular tool to bet on falling prices in the market. A put option gives you the right, but the obligation, to sell the underlying security at a certain price (the strike price) by a certain time in the future. The seller of the put option carries the downside risk and gets paid the option premium by the buyer.
Put options with a strike price above the current market price are also called “in the money”, as they give the holder the right to exercise the put option (sell the underlying security) at a higher price than the current market price. Put options with a strike price below the current market price are also called “out of the money.”
Use Inverse ETFs to Bet Against the Market
If you think the market is going to plunge, you can also invest in inverse exchange-traded funds (ETFs.) Inverse ETFs are moving inversely with the market they’re tracking – they go down when the market goes up, and go up when the market goes down.
Inverse ETFs are perhaps the easiest way to bet on falling prices in the long term. Popular inverse ETFs include the Rydex Inverse S&P 500 Strategy Fund that moves inversely to the S&P 500 index and the DB Crude Oil Short ETN that moves up when oil moves down.
Inversely Correlated Asset Classes
Finally, traders can also profit in bear markets by investing in inversely correlated securities and asset classes. For example, bonds tend to outperform the stock market in times of recessions as investors are looking for a safe haven to park their capital.
Gold is considered a secure investment in times of market turmoil (take the 2008-2009 financial crisis for example), and in the FX market, the Japanese yen and the Swiss franc often appreciate in times of low risk appetite among investors.
Important Tips when Shorting in the Long Run
Traders can increase their success rate when short-selling by following some important tips.
- Sell short only in bear markets – Before placing your trade to bet against the market, make sure that a new bear trend has started. Timing your trades can be very hard and picking the top of a bull run is tricky, but by following peaks and troughs in your chart (higher highs and lower lows) and spotting changes in market fundamentals, you can catch a new downtrend early in its development and significantly increase your profit potential.
- Do your analysis and control risk – Whether you’re buying or selling in the market, trading without a sound analysis and strategy is always risky. Money in trading isn’t made by taking trades, but by picking the right ones and sticking to them.
If you’re thinking that a new bear market is just around the corner, make sure that your view is confirmed by market fundamentals, consumer confidence indicators, and technical analysis.
In addition, since taking short positions theoretically carries a risk of unlimited losses, make sure to use a stop-loss level in all of your trades and only risk a small percentage of your trading account on a single trade.
Even though picking the top of a bull run can be very tricky, traders who do their analysis and follow the technical picture can short-sell the market in the early phases of a new bear market. There are many ways to profit from falling prices during a downtrend.
Traders can short-sell the market by borrowing securities from their broker, selling them in the market at the current market price, and repurchase them later at a lower price, making a profit on the difference between the selling and buying price.
Other popular ways include the buying of put options, which give the buyer the right but not the obligation to exercise the option at the strike price by a certain future time. When buying a put option, the buyer pays the seller the option premium, which is the only cost associated with options trading.
Traders can also buy inverse ETFs or invest in asset classes that are inversely correlated with the market they want to short. Inverse ETFs move in the opposite direction of the market they track – if one market goes up, the inverse ETF moves down and vice-versa.
There are many ways to take advantage of falling prices in the market, but traders still need to control their risk and limit losses by using stop-loss orders on all trades.