Two strategies stand out to profit in a bear market: short selling stocks and buying put options.
Both are ways to profit when the market is weak, but that’s where many similarities end. Ultimately these are very different positions to take in the market, with very different risk profiles.
For those considering getting into bear-side investing, here’s what you should consider before diving in.
A short sale is when the trader borrows shares of a stock and sells them at the current price. So, instead of owning the stock, he owes it and has to eventually buy back and return the shares to the original lender. If the stock price goes down, he makes money by buying back those shares for less than their original sale price.
So, for example, if you short sell 100 shares of GameCo., what you’ve done is gone to the market and borrowed those shares from someone. You sell them at $10 and make $1,000. Now, at some point, you have to buy back and return those stocks to the original owner.
So you wait until GameCo. hits $9 per share, buy back for $900 and return the shares to their rightful owner. You make $100 off the whole transaction.
From a strategic position, there are two critical distinctions to shorting:
First, you have to fund a margin account and often pay interest on the value of the borrowed stocks. This can make short selling expensive in the long run.
Second, you can liquidate your position at any time. This gives you the flexibility to move at any date and price, instead of having to wait out a pre-fixed position.
Put options are an agreement to sell an asset at a given date and price. For an up-front premium, the trader gets to choose whether they execute this contract.
Let’s say a trader contracts to sell 100 shares of GameCo in one month for $10 per share. When the contract comes due (the “strike”), GameCo is selling for $9 per share. So, she buys her shares for $900 total on the open market, then resells them for the agreed upon price.
She makes $1,000 off the option contract, and after her initial expenses, our hypothetical trader has made $100.
The critical distinctions to a put position are:
- First, vastly lower risk. Your premium cost is the total exposure, as there is no margin account, no interest and no commitment to the option buyer. You, the trader, can always walk away.
- Second, much less flexibility. Your strike time is contracted and so is the price.
This is great if you do a good job predicting the market. On the other hand, you’re not free to take advantage of price fluctuations during the term of the contract. If the price dips earlier or lower than predicted, you can’t make any money off of it.
This makes put options much less useful during periods of high volatility when you’ll want to seize opportunities, and much more valuable during predictable descent.
How to Choose
Although every trader’s position is different, take these two key metrics to heart.
- What is your appetite for risk? Short selling creates much more exposure than put options, and there’s the potential for catastrophic loss if a stock does unexpectedly well.
- How much flexibility do you want? An options contract is a prediction that’s locked in. If the stock price dips and then climbs back before the strike date, that’s just tough luck. A short sale, however, can be held longer or liquidated sooner depending on price.
The choice is up to you. We can help you make the Best Choice.