How to profit from the inevitable sell-off

Downturns are a fact of life -- even in bull markets. But for smart investors, it's an opportunity to profit.

By StreetAuthority Oct 22, 2013 1:30PM
Image: Arrow Down Umbrella (© Photographers Choice RF/SuperStock)By David Goodboy                                                                        

The stock market has been on a wild roller-coaster ride recently.
 
Political posturing, the government shutdown, debt default fears and an earnings smorgasbord have all hit stocks at the same time -- but despite the bumpy ride, the action has been textbook for experienced investors.

We witnessed the fear of a government default knock shares lower for several weeks, and then rumors of a solution sent markets surging higher. However, when the final-hour solution was finally announced, stocks slumped. This sell-off may have left many investors dumbfounded on why stocks sold to great news -- but it happens often in the financial markets.

This is a classic example of the "buy the rumor, sell the news" effect. Hype and perception have a more powerful effect than reality on short-term stock price movement. In other words, the excitement associated with the possibility of a bullish event is the true bullish price driver. When the actual event occurs, the bullish excitement is gone, and the big-money investors take profits, sending the market lower. It may seem counterintuitive that perception matters more than reality for short-term stock price movements, but that's the typical pattern.

Many other factors can cause stock prices to drop. Macroeconomic fears affect the broad market in a negative way, and individual stocks can get knocked down for dozens of reasons: missed earnings estimates, poor quarterly results, negative rumors, management shenanigans, even simple profit-taking.

The good news is that savvy investors can profit from this inevitable negative stock market action in three primary ways.

1. Shorting shares
The most popular way to profit from a down market or stock is through shorting. This means you place a trade in anticipation of the price falling rather than appreciating. I know it sounds complicated, but it's actually quite easy.

The way it works is, your broker loans you the shares at a certain price. The goal is to sell the shares back to your broker at a lower price, and you get to keep the difference between the loaned (short) price and the price that you sell the shares back to your broker.

Selling the shares back is called covering. Shorting can be done with individual stocks or exchange-traded funds (ETFs). An ETF such as the SPDR S&P 500 (SPY) can be shorted to participate in broad market sell-offs. You need to have a margin account and be approved for short selling at your broker in order to sell short.

2. Put options
While there are all kinds of different option strategies for a wide variety of stock market conditions, buying a put is the simplest way to profit from a decline. A put option is a bet that the stock or ETF will fall in price within a certain time frame. It climbs in price as the share price drops.

Buying a put limits your downside risk to the price you paid for the option. However, puts are very time-sensitive. This means that not only does the underlying share price need to drop, but it needs to drop within the lifespan of the put. Most puts expire on a monthly basis, and they all decrease in value as the time to expiration draws closer.

Puts are highly effective tools for betting on a particular known event's effect on price. If you anticipate the earnings report will be bad for a particular stock, buying puts to benefit from the resulting price drop makes sense.

3. Inverse ETFs
ETFs have opened new markets to investors.

Today, investors can access markets, indexes and complex trading ideas with the same ease as purchasing a share of stock through ETFs. A certain breed of ETFs known as inverse ETFs earns profits when the underlying instruments drop in value. This is accomplished by a complex mixture of future contracts and other derivatives to obtain the inverse movement in the ETF. Fortunately, as investors, we don't need to fully understand the mechanics of how inverse ETFs actually work. Our job is to understand how to use them for maximum profit.

Inverse ETFs are available on a variety on underlying stock indexes. There are even inverse ETFs that leverage the underlying index as much as three times. In simple terms, 3X leveraged inverse ETFs move 3 points for every 1 point the underlying index moves. This leverage makes them extremely volatile, and they're designed to follow the daily motion of the index not the long-term motion. This makes leveraged inverse ETFs only suitable for shoort-term, sophisticated investors who fully understand the risks and how they work.

Examples of inverse ETFs include ProShares' Short Dow 30 (DOG), Short S&P 500 (SH) and Short MSCI Emerging Markets (EUM). Leveraged inverse ETFs include Direxion's Daily Large Cap Bear 3X (BGZ), Daily Real Estate Bear 3X (DRV) and the aptly tickered Daily Health Care Bear 3X (SICK), among many others.

Non-leveraged inverse ETFs can be bought and held just like any stock. They are ideal for catching long-term down trends in whatever the underlying instruments are.

Risks to Consider: Shorting stocks goes against the long-term upward trend of the stock market. However, it can be a highly effective tool for profiting from negative events and other sell-offs. Theoretically, your risk is unlimited should a shorted stock keep going against your position without you taking the loss. However, in reality, stocks don't move upward forever. Regardless, shorting stocks is risky, requiring timing and experience. Buying a put or using non-leveraged inverse ETFs is a much simpler way to profit from an expected sell-off. If you are able to time the selling, a triple-leveraged inverse ETF makes sense for a short-term holding period. Be prepared for heavy volatility.

Action to Take: Practice shorting stocks in your demo account. Most brokers have a demo platform that allows you to practice various investments and trades. Try a leveraged inverse ETF and buying a put in your demo account as practice before using real money. Note how the investments move relative to the underlying instrument, as well as how much margin is required to short directly. If you take the time to practice shorting, your chances of not making rookie mistakes with real money increases exponentially.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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38Comments
Oct 22, 2013 5:49PM
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The challenge here is to know when the Fed will stop printing the funny money that is supporting the market.  Without the Fed money, the market would be in the range of 10,000 to 11,000.  Just look at the companies that have just reported their financials.  Almost half have not increased revenue or had a decline in revenue, yet reported higher profits.  You can only do this by cutting expenses and/or utilizing some accounting gimmicks.  Yet, after they report higher profits, the stock goes up, even though they are not generating sufficient revenue to grow.  This reporting circle of declining or stalled revenue will eventually be the demise for a lot of companies.  You can only layoff so many people and utilize only so many accounting tricks before you hit the wall.  Yet, the market tells these companies that thye have ever-increasing value.  I don't think so.   
Oct 22, 2013 1:59PM
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How about selling shares and holding cash, buying a little GLD and GDX and waiting for DC to burn?
Oct 22, 2013 4:03PM
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all markets go up and all markets go down. the problems is figuring out when they are going down. any idiot can make money if they know when they are going down. the problem is most people don't know when they are going to drop till it's too late to take advanatage of it.

i don't think this market is going down any time soon. too much driving it, but watch around christmas and see how the seasonal shopping goes. a bad season could take some wind out of the sails

Oct 22, 2013 6:47PM
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I get so tired of these gloom and doom people.You buy good stocks and enjoy the dividends.
Oct 22, 2013 6:37PM
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under Obama and his minions the market more than doubled since the bush crash.

Oct 22, 2013 6:40PM
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gld and gdx are not protection against Washington ....they are inflation hedges.  if Washington burns

there will be DEFLATION and gold will be worth less than clean drinking water and canned tuna fish

Oct 22, 2013 6:38PM
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"The good news is that savvy investors can profit from this inevitable negative stock market action in three primary ways."

I thought that helicopter Benny's policies were SUPPOSED to prevent this sort of thing.

Seems to me that all those so-called "gloom and doomers" MAY be right.

 

Benny DOES NOT have the answers.

 

SURPRISE!!!!!

 

Oct 22, 2013 7:04PM
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See that all the "frauds" are posting.  Wonder how many "nicks" the Fat, has?  The "market" or "markets" can do what they will as they must.  If the "printing" is stopped, which will never happen, the "markets" will crash....really who cares at this point?.  .   Half the nation is on "welfare" of one type or the other and that is simple as known.  This "guy" in office.....well, we all get that now or we are just plain stupid.  This "idiot" socialist (worse) is counting on that.  The "vote" coming in another year will be the same.  Hand out the checks and get the vote.  It is that simple. 
Oct 22, 2013 11:51PM
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So we're told "smart investors" profit from futures and leveraged ETFs?  Those things cause more people to go broke than profit.

First, we need to know then stocks are going to decline.  After they decline we're supposed to know when the beginning of the next bull market is happening.  Lotsa luck!

Oct 23, 2013 12:32AM
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David,  your description of shorting isn't quite correct.  You borrow shares sell them and pocket the money.  Then when the stock goes down, you buy the shares back, return them to the broker and keep the difference.  You are also responsible to pay any dividends to the owner of the stock you have borrowed plus transaction costs.
Oct 22, 2013 4:15PM
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How to know when the market is due for a serious correction?  Watch Obama's minions in the Media.  As soon as they start blabbering about what a great job he's done with the economy, we'll go over the cliff.
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Pretty much the Federal Reserve has run it's course. It has now successfully bankrupted the USA by forcing us to under collect taxes (mostly on the super rich) and over expnd the role of government in order to increase government spending while ham stringing it's ablitity to collect revenue.

 

However the Federal Reserve has no end game now. Use to be they would hit the inflation button for a while but when they tried that last time they triggered the financial collapse. So they are stuck now.

 

It's all down hill from here folks.

Oct 22, 2013 3:07PM
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One would think that the market has to fall at some point. Look at all the little crack-babies who wanted nothing to do with stocks in March '09 or September '11 piling into stocks now!
Oct 22, 2013 8:36PM
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And gold isn't doing too bad, along with silver it might just get better, arf, arf..
Oct 22, 2013 8:35PM
Oct 22, 2013 4:15PM
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Legalized gambling is all it is. 'profit, profit, profit. Money money money how much money money money can we make! It's a sickness.
Oct 22, 2013 5:21PM
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SO ?   Who are the suckers still playing the securities con game?
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