Editor’s note: This article was first published in January 2018. Binary options “being pursued by the SEC” reflects 2018; since then ESMA and many national regulators have banned or restricted binary options and CFDs for retail investors. Google at 1,000 dollars is a 2018 example, before Alphabet’s 20-for-1 split in 2022.
As most of you will already know, on the stock market you can make money both when shares, indices and commodities go up and when they go down. This is what is known as short selling, bearish positions, going short and so on. In other words, you can invest and make money when the market falls.
There are some technical differences between naked short selling, margin short selling and short selling, but for the purposes of this article we won’t go into detail. We will only explain the ways an investor can make money in a falling market, which product is most advisable for each situation (in my personal opinion), and which products are the only ones that can move the actual price of a share when we open a bearish position. So let’s get to it.
What products can you use to make money when the market falls?
We’ll split this section into the products that can move the market and those whose speculation does not affect prices.
Products that move the market
- Short selling, naked short selling or margin short selling (for our purposes they are the same thing)
- Futures (not directly, but indirectly)
Derivatives that do not move the share price
- CFDs
- Options
- Warrants
What does going short or short selling mean?
When you expect a share might lose value (its price might fall), the idea is not to buy shares but to sell them with the promise of buying them back later, pocketing the difference between the moment you sell them and the moment you buy them.
Put like that it may sound complicated, so let’s explain it with an example.
Suppose we want to go short on Google, which trades at 1,000 dollars.
- When opening a bearish position, what we do is borrow Google shares to open the short.
- We sell the Google shares at 1,000 dollars.
- Google falls to 700 dollars, and then we buy the shares at that price (700 dollars).
- We return the shares to their owner and pocket a profit of 300 dollars per share, minus whatever interest we agreed on.
But what if the price rises instead of falling after you open the short?
If we open a short by selling at 1,000 dollars and, instead of falling to 700 dollars, the price rises to 1,200 dollars and we decide to cut our losses, we would buy the shares at 1,200 dollars, so we would have lost 200 dollars per share.
The difference between short selling, margin short selling and naked short selling
Although the differences are insignificant, by definition these would be the technical differences (in practice they work the same way).
Short selling
As a rule, the broker holds the shares and the investor borrows them in order to sell them, with the aim of buying them back at a lower price, returning them to the broker and pocketing the difference.
Margin short selling
The same as short selling but with leverage. In other words, we can trade shares worth more than the money we have at that moment. Basically, it means that with 1,000 euros we can invest as if we had 10,000 euros. The good thing is that if the trade goes as we expected, we could make a lot more money (we earn on the basis of 10,000 euros instead of 1,000 euros), but if we get it wrong, we also lose on the basis of 10,000 euros instead of 1,000 euros.
See also: Stock market forecasts for investors: how absurd!
That’s why in this case the broker requires collateral from us, and if the price moves against us, the broker can demand more collateral or close our position immediately at a loss.
Naked short selling
This works the same as short selling. We can sell the financial asset without having bought it first, intending to buy it at a lower price and earn the difference. Unlike margin short selling, no collateral is required.
Why does short selling move the actual share price?
Unlike the rest of the products we are going to explain, when we open a short sale or a margin short sale, we really are selling shares on the market. That is, we are placing a sell order.
Even so, bears provide liquidity to the markets. Imagine some bad news comes out about a company that is going to cause a 30% drop. Everyone starts selling and, logically, there shouldn’t be any buyers yet.
But buy orders appear in the market. They are usually the bears taking profits, and since to take profits they have to buy rather than sell, investors who want to get rid of their shares benefit from this type of investor being around.
That’s why shares often have technical rebounds within a clearly bearish trend. In many cases it isn’t that buyers are coming in, but that the bears are taking profits.
Investing with futures
Both futures and options involve buying this derivative at a set price, for either a rise or a fall, over a given period of time.
Investing in futures, as the name suggests, means setting something at a future price. That is, if I believe that an asset worth 20 euros today will cost 30 euros in three months, I acquire a future on that asset and am required to put up collateral today to meet my obligation. If after those three months the asset has risen above expectations, I will have earned that difference in price. And the same applies on the way down.
These products are often used to hedge our investment portfolio. In other words, if I hold IBEX shares and a fall is expected but I don’t want to sell my shares, I can buy bearish (PUT) IBEX futures so that the loss in the value of my shares is offset by the gains on the futures.
Why do futures move prices indirectly?
Although futures going up or down does not really exert direct force on the markets, and we are not selling the underlying assets, futures are usually taken as an indicator of investor confidence in a particular asset. As a rule, futures prices and the price of the underlying asset tend to end up converging.
If futures point lower for the IBEX, it is very likely that the IBEX will fall at first. If the index then starts to rise, those investing through futures will begin to speculate using the market trend as their reference. In short, prices tend to even out.
Investing through options
As with futures, this means taking a position through the derivative at a future price and with a deadline. It gives us the right, but not the obligation, to acquire the underlying asset it is linked to at an agreed price, known as the strike or exercise price, once the date on which we must close the position arrives. All we pay for that right is a premium, and that premium is the most we can lose on this type of trade.
As with warrants (which we’ll look at next), we have bullish positions, where we expect the price to rise (CALL), and bearish positions, where we expect the price to fall (PUT).
For a simple explanation of both futures and options, this PDF guide from the CNMV (Spain’s securities regulator) has a clear explanation with lots of examples. It’s free.
Investing through warrants
Warrants work in practically the same way as options. In fact, if you know how options work, you know how a warrant works.
As with options, we pay a premium to acquire the warrants at a set price (the strike price) for an agreed deadline.
The difference between options and warrants
Options are contracts between two parties, with your counterparty being a person or institution that holds the underlying asset or wants to acquire it.
Warrants, on the other hand, are contracts between the investor and the financial institution or bank, so your own bank acts as the counterparty. That is where the fear some people have of this product comes from.
It’s true that most warrants and options are designed, in terms of time and price, to lose money. Even so, they can be very profitable if we choose the asset and the moment well.
Both options and warrants need volatility so as not to lose value. And as the expiry date approaches, they begin to lose value. That’s why the expiry date is rarely reached, since the warrant’s price tends towards being worthless.
They are known as “one step forward, two steps back” products: a warrant can gain 10% on a 2% rise, but then lose that 10% on a 1% fall, especially if the expiry date is close. That’s why, when we buy options or warrants to speculate and the trade doesn’t go as expected, the smartest thing is to cut the loss as soon as possible.
Investing with CFDs
Probably the most fashionable product for intraday trading. Unlike the others, with this product we have no rights over the underlying asset. The CFD replicates the price of the asset.
The counterparty with this product is usually the platform itself or other investors (players) on it.
This product was designed solely for speculating and making money on the movements of shares, indices, commodities, currencies and so on. Its popularity usually comes down to the low commission per trade and how easy it is to use leverage. We can also keep a position open after the market closes by paying a small fee, which makes it an ideal product for a short trend (a week or a couple of weeks).
Which products to use in each situation?
Warrants and CFDs are ideal for speculating intraday or on very short trends, while for longer trends of 3, 6 or 12 months we could turn to futures or short selling. Options would also work.
The other way to make money in a falling market is the DCA strategy, although this is more of a long-term strategy and at no point do we open shorts. Rather, it consists of averaging down, that is, buying the asset as its price falls and so accumulating shares at an ever lower price. It is suited and useful above all for an index fund or for dividend-paying shares.
These are the choices we have for going short when the markets or a particular share fall or, at least, for taking advantage of stock market falls to make money.
A product to avoid: binary options
With the variety of options and products for investing on the downside, and with many of them already looking like a casino, I would at least avoid binary options. Without going into detail, I’ll say that most of the ones we have analysed cheat, which is one of the reasons they are being pursued by the SEC and why these companies are headquartered outside the reach of regulators.
Finally, a reminder: before investing, speculating or gambling, try to learn thoroughly how the products work, because with some products your losses can exceed the capital you invested.
Recommended reading: The science of bearish positions
Featured image: Stang_wm, CC BY 2.0, via Wikimedia Commons.
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