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How would one profit from a share price falling, granted that they correctly predicted it would happen?

Say I had a hunch that a certain stock was going to fall next week, how could I effectively make a profit on this.

GS - Apologise to Monica
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Welz
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4 Answers4

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The three normal ways to profit from falling stock prices are:

  1. Short sale: Borrow someone else's shares. Sell at current price. Wait for price to fall. Buy back at lower price. Return shares to owner. This has unbounded upside risk should share price increase significantly.

  2. Sell/write call options with strike price above current share price. If share price does not rise above the strike price, the calls will expire and you will keep the money made from selling them. If the calls are naked, the risk above the strike price plus premium received is the same as being short the stock.

  3. Buy put options with a strike price lower than current price. When stock drops below strike price of put, either buy shares at new low price and exercise the option to sell at a high price, or sell the option. The most you can lose is the cost of the long puts.

All three of the above are risky, especially for a novice investor and are not recommended to anyone without significant experience and understanding of derivatives.

Bob Baerker
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  • I'm confused - you give three things that you should not do, but all 3 answer the question, are you saying that these are the ways you would do it but that you should not? – D Stanley Jan 23 '18 at 23:57
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    I think he's saying that's how it works, but me personally (since I had to ask) shouldn't do it. I would edit it to say "these are the methods... but one who has to ask, probably shouldn't do it" – Welz Jan 24 '18 at 00:05
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    @D Stanley: These are three ways to profit from a falling stock, but two of those methods carry significant risk if you are wrong. So while you could, if you are asking the question you should not – Rocky Jan 24 '18 at 00:17
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    Great info, but I think there is a better way to explain the risks than to be patronizing. Everyone who knows something started by not knowing something and asking. – le3th4x0rbot Jan 24 '18 at 06:39
  • Also what about purchasing out of the money call options to set an upper limit on short sale losses? – le3th4x0rbot Jan 24 '18 at 06:46
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    @BaileyS Ah, yes, that works, it's basic hedging. But if you do that your prediction is not just that the price will fall, it's that the price will fall by more than the call option cost by the time of the option expiration, and how far out of the money the option is becomes another risk factor that needs careful analysis. An easier way would be to setup a passive order or stop-loss, but then you restrict how the price can move. There's a good reason why most brokers will require you to sign extra papers if you want to do naked shorts, and it's not because they are patronizing assholes. – Ordous Jan 24 '18 at 12:33
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    @BaileyS "Everyone who knows something started by not knowing something and asking." Not universally true. There are other methods of learning beyond asking. Researching at the library, taking a class in a school, experimenting, etc. And the current version (not sure if it's been edited) doesn't read as patronizing, but as plain truth. If you have to ask about how to profit on declining prices, you probably aren't ready for the risk involved. – Xalorous Jan 24 '18 at 16:49
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    I've modified the patronizing bit while retaining the significant (and justified) warning tone. "If you have to ask..." is never appropriate in my opinion; that suggests people should not do research, and assumes they will make poor choices rather than they are asking for basic information to build their knowledge. Asking a basic question certainly justifies a significant warning, but not the patronizing tone. – Joe Jan 24 '18 at 17:02
  • Re: Hedging. A hedge may have corner cases where the hedge fails. For example stop loss orders turn into market orders and in a fast moving market, the price at which the order is filled could be significantly different than the stop loss amount. – Shannon Severance Jan 24 '18 at 18:00
  • @BaileyS Also, you have to factor in counter-party risk. What if the hedge counterparty defaults? – Yakk Jan 24 '18 at 18:01
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    @joe "If you have to ask" is accurate here. The point is that if you are asking about this, this means you don't know enough to safely do any of these at this point. You should be well past the point of understanding these choices exist before you should consider doing them. – Yakk Jan 24 '18 at 18:02
  • Aren't "futures" a fourth way? (I'm not an investor, my understanding is limited) – BlueRaja - Danny Pflughoeft Jan 24 '18 at 18:35
  • @BlueRaja-DannyPflughoeft put/call options with certain price targets are synonymous to futures trading.

    Also... remember shorting has limited gain (price going to 0) and unlimited liability (as high as price goes).

    – Crosscounter Jan 24 '18 at 19:52
  • Option one is pretty much the same as doing both Option 2 and Option 3. – Acccumulation Jan 24 '18 at 20:24
  • @Yakk It's patronizing and condescending, whether you feel that it's accurate or not. An adult is free to choose whether or not he/she wishes to get involved in trading; there are ways to warn people of dangers without making them feel badly for asking (as my edit demonstrates). – Joe Jan 24 '18 at 20:29
  • Which of these might make a government body think very hard about charging you with a crime if not done exactly right? – jpmc26 Jan 25 '18 at 03:29
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    Without asking you won't learn and become experienced, and just because you go short does not mean that you are willing to risk unlimited amounts of money - just like going long does not mean you are willing to risk all of your investment. You should be using risk management whether you are going long or short. Once you actually get some experience with going short you will find it is not much different than going long. – Victor Jan 25 '18 at 09:15
  • @Victor This comment shows exactly why "if you have to ask, you should not..." applies. There is NO upper bound limit to the losses. You can lose HUGE amount of money shorting stocks (many times what you put in is possible), because you cannot control the upper bound of a stock's value. Stocks can hit 0, but there is no mechanism to make it not go over a certain value. https://www.fool.com/investing/general/2015/06/17/netflix-inc-stock-a-horror-story-for-short-sellers.aspx 950% growth in 3 years. You shorted $1,000 on Netflix, you just lost $10,000 after 3 years. VERY risky. – Nelson May 21 '20 at 02:58
  • @Nelson - firstly, why would anyone be short on Netflix for 3 years without even checking on that trade anytime within that 3 year period. I never said shorting is a buy and hold strategy!!! Secondly, your broker would have closed you out once things start going against you and you haven't answered any of the margin calls they have been sending you. And thirdly, which is why I stated that with any sort of trading (long or short) you should have risk management in place, so you would have closed out of the trade once you maximum loss tolerance was reached. – Victor May 22 '20 at 01:36
  • @Nelson - my clear message is to gain experience with it and use risk management, and a clear way to gain experience is to ask questions and practice on pretend accounts without real money! – Victor May 22 '20 at 01:38
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You can short sell shares, buy put options or write call options as noted above, but make sure you have stop loss orders in place if you are going long or short.

Another method you could use to also profit from a falling market is to buy bear ETFs (Exchange Traded Funds), you can use these to trade the market as a whole or to profit from falling sectors or whatever else might be covered by bear ETFs.

And if you are not in the US, you can trade CFDs (Contracts For Difference), which you can go both long and short in. But again remember to not overtrade (as CFDs use margin) and to use stop losses appropriately.

Victor
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    Can you please add what the acronyms are (for us noobs) – Welz Jan 24 '18 at 02:27
  • I think "bear ETFs" is a good and unique element of this answer, and it might bear a bit more of explanation. – Joe Jan 24 '18 at 17:09
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    @Joe - simple just as the name suggests, for eg. if you buy a S&P500 Bear ETF and the S&P500 index falls the Bear ETF will rise in price and you make money. – Victor Jan 25 '18 at 09:07
  • @Victor I know what it means, but given the simplicity of the question I think it might justify some explanation in the answer (a paragraph or two). It's what your answer really brings to the table. (Also, some note about the disadvantages of bear ETFs versus regular ones - seeing "ETF" might make someone think it's a totally safe thing that's reliable in making money...) – Joe Jan 25 '18 at 15:57
  • @joe - are you trying to say that standard ETFs are totally safe and you can't lose money with them? You can lose money with any investment just as you can lose money with bear ETFs. – Victor Jan 25 '18 at 22:43
  • @Victor Absolutely not; any investment carries risk. But standard ETFs are reasonable investments for an investor who wants to put money in the market and come back in 20 years. An inverse/bear ETF is not; it's a package of derivatives that should be day-traded. Bear ETFs are not suitable for holding long term - for even a few days - as they compound risk. Most people see "ETF" and read "good idea for a novice investor". Bear ETFs are not as dangerous as short-selling yourself, but they're not that far off. – Joe Jan 25 '18 at 23:12
  • @Joe - if anyone buys any investment and forgets about it for 20 years, well that is as risky as anything. That means they have no plan and no risk management, all they are relying on is hope. The OP asks about how to profit from a falling market - a bear ETF answers the question. If I heard a new term I would investigate and learn about it before investing in it. If someone is going to invest in something they just heard about on a website without learning about it first, then they are just after the next quick fix, and are bound to lose their money sooner or later. – Victor Jan 26 '18 at 00:35
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You can profit from a share price falling by what is known as shorting the stock. Effectively you borrow the stock from a broker willing to loan it to you at the current price then 'sell' it back to them when the price of the stock falls. The difference is yours to keep.

Be warned however this is a risky position to take as it now exposes you to theoretically infinite losses if the stock moves the other way. When you're 'long' a stock, you can only lose the money you spent on it.

Andy
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    Great example of what can go wrong here. – Craig W Jan 24 '18 at 00:01
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    @CraigW It's an even better example of what can go wrong when you look up their current price - he was absolutely right, and the stock cratered down to a current $0.40 value. He just wasn't right at the right time. – ceejayoz Jan 24 '18 at 02:23
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    "Markets can remain irrational longer than you can remain solvent." – CodesInChaos Jan 24 '18 at 21:48
  • Answer unclear. To clarify, when you short a stock you borrow the stock from your broker or through your broker. Then you sell that stock on the market. If the price drops (rises), you buy it back at a lower (or higher) price and return it to the broker with interest (unless you're daytrading). The difference is your profit (loss). – misantroop Jan 26 '18 at 02:43
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Ways to benefit if a security is dropping:

1) Short the shares if they are borrowable and the borrow fee isn't huge. This requires a margin account. Borrow fees can be as low as 0.25 pct or crazy numbers like 50-75-100% per year. Buy them back for a profit if price drops. Buy them back for a loss if they rise.

2) Buy put options. To capture smaller moves, buy ITM puts. They will lose more than OTM puts if you are wrong. For leverage, buy OTM puts. If you get a big move, the ROI is higher than with ITM puts. If wrong, you will lose less (on a 1:1 basis). The delta of the option will tell you how much the option should gain (or lose) per point of stock movement. Delta is non linear and affected by the level of implied volatility so keep in mind that it's an approximation.

3) Sell/write covered calls. If they expire, you keep the money made from selling them. This is more of an income proposition and unless the calls are deep ITM, they will hedge the underlying poorly (small premium against large underlying drop). And as the stock drops, you may find yourself in a position where there is no strike price that you can write without locking in a loss.

(1) (short stock) is the only dangerous choice.

(2) (long puts) has limited risk.

(3) is an opportunity risk if the price rises and you are assigned and must sell the stock at the strike price (you don't participate in the upside).

If you want a global approach, you can buy inverse ETFs but they bear a similar risk to shorting.

Shorting is risky and should only be don by those who are experienced and who practice good risk management. While it is true that there are "theoretically infinite losses if the stock moves the other way", that's just not reality. No stock has ever gone to infinity and no big cap stock will ever do this. You manage a short position just as you manage a long position.

Bob Baerker
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