Eyeing the Downside: Three Ways to Short the Market

Are you looking for ways to hedge against or capitalize on market downturns? Perhaps you’re looking to do a little of both—that is, to hedge your current stock holdings while opening new positions to seek profit off the downside of a falling market.

Either way, whether you’re looking to protect against or profit from a bearish turn, perhaps the most direct approach is to simply “go short” the market; that is, sell an asset at a higher price now, with the aim of buying back the same asset at a lower price later. It’s still the same “buy low and sell high” principle that underlies all investment practices. You’re just doing it in reverse.

Three Ways to Get Short

There are many ways to play the upside of a downside market. Some approaches are relatively simple, while others can be quite complex. Some approaches come with limited risks, while others may expose you to unlimited risks. For starters, here are three relatively straightforward ways to get short the market using stocks, options, and futures.

Before we continue, note that in order to sell short with any of these approaches, you’ll need (respectively) a margin account for stock trading, an options account, or a futures account.

Shorting Individual Stocks

Risk: Unlimited, as there is technically no limit to a stock’s upside

Aim: To seek profit from price declines

Here’s a hypothetical scenario. Suppose you sense weakness in stock XYZ. Its overall fundamentals appear unhealthy; its earnings capacity seems weak. You’re anticipating its decline, and you aim to generate a positive return when it drops. 

Stock XYZ is trading at $50 per share, but you think it’s worth much less than its current valuation. So, you go short 100 shares, a total net position of $5,000. Then XYZ falls to $35 per share and you “buy to cover” (i.e., buy back) 100 shares at that price. Essentially, you bought low (at $35) and sold high (at $50) 100 shares, but in reverse order. Your profit before commissions, fees, or other payments such as dividends (should they apply) would be $15 or $1,500 (15 x 100 shares).

Now, if stock XYZ had moved in the opposite direction by the same amount—if its price had risen instead of having fallen—you would be at a loss of $1,500 (more if you consider the commissions, fees, and other applicable payments). Before you jump in, learn more about the basics of short-selling stocks.

What about shorting stocks to hedge long positions?

What if your aim is not to profit from a stock’s decline, but to protect your current stock positions? Can you place a direct hedge to protect your stocks? The answer is no; you can’t place a direct “short” hedge to match, stock by stock, your current “long” positions.

Buying Puts or Put Spreads

Risk: Limited if you’re long an option; limited if your short option is protected by a long position

Aim: To seek profit from price decline, or to hedge a position in the underlying

One way to potentially benefit from a stock’s decline would be to buy a put option. A put option gives the buyer the right, but not the obligation, to sell the stock at a predetermined price (the “strike” price), at or before a specific date (the option’s expiration date).

When it comes to gaining short exposure on a stock, in contrast to a straightforward short sale that exposes you to unlimited risk, buying a put limits your risk to the price—the “premium”—you paid for that put.

Purchasing a put may be a relatively simple transaction, but that doesn’t mean option contracts are simple instruments. There’s a lot that goes into the mechanics of options trading. And before you jump in, there are plenty of fundamentals that you need to cover. But once you become relatively familiar with options trading mechanics, you may discover a whole new world of trading strategies geared toward uptrending, downtrending, and even non-trending markets.

Selling Short Futures Indices

Risk: Unlimited, as there is technically no limit to an index or commodity’s upside,
OR limited if you hold the underlying instruments

Aim: To seek profit from price decline, or to hedge a position in the underlying

Similar to shorting stocks, you can sell (short) a futures contract to seek positive returns from the price decline of an index, commodity, or currency. Because futures include “equity” indices like the S&P 500 (/ES), Dow Jones (/YM), and Nasdaq 100 (/NQ), you can also short indices to hedge your equities positions, as long as your positions are large enough to match the futures’ dollar-per-tick value, and correlated enough to match the broader index.

Bear in mind that futures trading can be exceedingly risky and is not for every investor or trader. Futures are highly leveraged instruments, which means futures can be capital-efficient, but also that it takes very little money to gain a lot of exposure … and things can move fast. Profits and losses are amplified. And because you’re trading on margin and using leverage that exceeds what’s typically available for stocks, you’re responsible for instruments whose total value may exceed the amount of capital in your trading account. If you’re not careful, you can lose more money than you have.

Markets run in cycles—sometimes up and sometimes down. The good news is that there are tools available to investors who choose to try to take advantage of, or protect from, the downside. If you think short strategies may be right for you, it’s important to understand the risks as well as the potential benefits. One place to start is to watch the video below.