As regular readers of this column know, the author does not have a positive view of current stock market valuations and pricing. I continually reiterate the importance of having a well-structured portfolio and strategy which provides downside protection.
Note that effective portfolio management is wise and recommended. Portfolio management is different from active trading with a directional view. However, in this column I am going to discuss several ways to actively trade and profit from a falling stock market. All of these strategies absolutely require that the trader understand the mechanics of the trade and the individual securities, the transaction costs, and the risks. Without this expertise, the author does not recommend these strategies.
The easiest way to express a view and make money when the stock market falls is to purchase shares in an exchange traded fund (ETF) which is designed to move inversely to a market such as the S&P500. In other words, the ETF’s price goes up by an amount approximately equal to the downward market movement. Of course the ETF’s price goes down when the market goes up. Many of these ETF’s exist. Several of them are even designed to return 2x or 3x the inverse of a market. A list of ETF’s is easily found online.
Most brokerage accounts and online trading platforms allow clients to sell short individual stocks or ETF’s. When a trader shorts a security, the trader does not own the security. The security is literally borrowed, sold, and hopefully repurchased at a future date at a lower price. The trader earns the difference between the sell price and the repurchase price. There are margin requirements in shorting a security which protect the lender and brokerage firm against adverse market movement. In other words, the trader must post collateral when shorting a security.
A trader can sell futures contracts on a market. S&P500 futures are one of the most actively traded and liquid futures markets in the world. When a trader buys or sells a futures contract the trader buys or sells the obligation to deliver the underlying security at a future date at the price which is set at the time of the trade. Selling a futures contract is similar to shorting a stock in that the trader hopes to profit by selling at a high price and buying the futures contract back at a lower price. There are margin requirements on futures contracts.
Options on individual stocks, ETF’s, and futures contracts can be bought and sold. An important part of options trading is the fact that when a trader purchases an option the trader’s potential loss is limited to the cost or the option, known as the option premium. On the other hand, a trader who sells an option is at risk of more loss. A put option gives the buyer the right to sell a security at a set price, known as the strike price, within a certain time frame, known as the expiration date. A view that markets are going to move lower can be expressed by purchasing a put option on an S&P500 futures contract, an ETF, or on an individual stock. For novice traders, an excellent thing about purchasing an option is that as noted above, the trader’s loss is limited to the option premium. An understanding of option pricing, analytics, and market structure is necessary.
Another way to express a view that stock markets are going to move lower is by being “long” volatility. Volatility is a component of option prices. This is called implied volatility. When implied volatility increases option prices increase. The VIX index has become a widely watched measure of volatility. It is a measure of the implied volatility component of S&P500 option prices. Over the last several months the VIX has moved to and remains at historically low levels. Historically when stock markets fall, implied volatility increases. This is why the VIX is referred to as the market’s “fear gauge.” There are ETF’s which reflect the level of the VIX.
In conclusion, active trading with a view on market direction is different from portfolio management, but it can play a part. It should not be your entire portfolio strategy. Be prepared to take substantial losses on the part of your portfolio which you actively trade. However, at times when you have a strong view on markets, actively expressing that view might enhance your returns. It’s essential that you understand the risks. The easiest way to express a view that stocks are head lower is to purchase shares in an ETF which moves inversely to a stock market index or sector.