Two Ways to Profit from a Falling Market
I recently wrote about inverse exchange-traded funds (ETFs) as vehicles for investors to bet against the market, in an account with margin restrictions such as an Individual Retirement Account (IRA).
In margin-enabled accounts, however, investors have the flexibility to short stocks and buy puts to profit from a fall in prices. Today, let’s take a look at these two common bearish strategies.
To short a stock, you sell a stock you don’t own. When you want to cover your short position, you buy an equal number of shares of the stock. The goal is to buy back the stock at a lower price than you sold it. You can use the cash proceeds from shorting the stock to invest in other assets, so you can boost your earning power.
Sounds sweet, right? But there are downsides.
You are able to sell a stock you don’t own because the broker will lend you the shares. Of course, the broker isn’t running a charity, so you have to pay margin interest on this loan.
The Federal Reserve Board’s regulation T mandates that you cannot borrow more than 50% of the purchase price. In the case of shorting, this means that your account must have other assets worth at least 50% of the value of your initial short position. In other words, if you are shorting a stock for $5,000, you must have at least another $2,500 worth of assets in your account that’s not borrowed.
In addition, FINRA rule 4210 mandates that the account holder’s equity in a margin account must not fall below 25%. For example, if the total market value of the securities in your margin account is $100,000, your equity must not be less than $25,000.
A broker may have even stricter internal margin requirements. Find out before you open a margin account.
The Dreaded Margin Call
If stocks move against you and you fall below margin requirements, you will face a margin call. The broker will require you to either deposit more cash or liquidate positions to raise cash until you satisfy the margin requirement. If you don’t remedy the situation in time, the broker has the right to forcibly liquidate your positions.
You should also be aware that shorting carries high risk. When you short a stock, the best outcome is for shares to fall to $0. The difference between the price at which you shorted and zero is your maximum upside.
But on the flip side, there’s no limit to how high the price can rise. Theoretically, when you short a stock the maximum potential loss is unlimited. If you are heavily short, and the market rallies sharply, things could get ugly for you quickly.
Considering a Put
On the other hand, if you buy a put, your loss is limited to the premium you paid. The worst-case scenario is for the option to expire worthless.
The downside to a put option is that it has a finite life and its time value decays. Even if the underlying stock falls, if the stock price doesn’t fall fast or sharply enough, you could still lose money.
When you short, there’s no expiration. As long as you satisfy margin requirements, you can keep the short position open for as long as you want. Moreover, as long as the stock price falls, you will be able to buy it back at a profit (not counting the margin interest).
So you bought a put, it’s in the money (the strike price is higher than the market price), and the expiration date is approaching. What should you do?
If you already own the underlying stock, and you bought the put as a hedge, you could just let the put option expire. Your shares will be put to the counter party at the strike price.
However, if you don’t already own the shares, usually it’s better to sell your put than to let it expire.
Options have time value, so you are likely better off selling the option than to let it expire. For example, as of this writing the General Electric (NYSE: GE) April 17, 2020 $8 puts ended trading on April 9 at $0.92. The stock price ended at $7.14.
If you exercised the option with GE at that exact price, you would realize a gain of $0.86 per share of GE (buy at $7.14 and sell at $8). But if you simply sold the option, you would get $0.92 per share of GE, or $92 per put contract.
Plus, in reality when you exercise the put option, you actually have to buy the appropriate number of the stock before option exercise. Otherwise, if the broker puts the stock from your account to the counter party, and you don’t have shares, you would be short the stock and need to buy the shares back later. And that exposes you to further risk (you could lose or gain depending on how the stock moves).
Shorting and put buying come with pros and cons. Which strategy you choose depends on your experience and preference. If you’re looking for seasoned advice on options trading, turn to my colleague, Jim Fink.
As chief investment strategist of Options for Income, Jim has made huge profits for his followers with his adept trading of options.
In fact, Jim has developed an options trading system that allows you to collect payments every Thursday, similar to a paycheck. Think of it as a “profit calendar.”
These payouts can range in value from $1,150 to $2,800, but average out to $1,692.50. Jim developed his strategy by studying the tried-and-true practices of Chicago pit traders and modifying them for use online.
It’s like getting an extra paycheck, week in and week out. The gain is so reliable, you can schedule it on your calendar. Jim made himself a wealthy man with his system. Now he wants to share his secrets with our readers.
Jim Fink makes money in rising or falling markets. How does he do it? Click here for his presentation.