The stock market is like just about anything else in life. It goes in cycles, with ups and downs. There’s an old saying that trees don’t grow straight to heaven. This also applies to stocks. Even during times of euphoria, there will be an end to the excitement, and gravity will eventually set in.
Beginners in the stock market tend to think about investing as buying stocks and making money when those stocks go up. That’s the most common way to profit from stocks, but it’s not the only way. Believe it or not, it’s also possible to make money when stocks go down. However, some strategies are riskier than others.
If you choose any of the following methods, be cautious. Never risk capital you can’t afford to lose. Taking small position sizes in all trades is important. Also, understand that betting against the stock market is a risky proposition. After all, the market has recovered from every crash it’s ever faced and gone on to rise afterward.
Now that you understand the risks, it’s time to learn some of the most popular ways to profit when the stock market declines. It’s not the easiest way to make money in stocks, but it’s worked well for some traders. Hopefully, it can work in your favor.
Short-selling index ETFs
Many ETFs track stock market indexes. These funds are traded much like stocks. They can be purchased and sold during market hours, and they’re available through popular online brokers.
The oldest and most popular index-tracking ETF is the SPDR S&P 500 ETF (SPY), which (as the name implies) follows the S&P 500. The PowerShares QQQ Trust ETF (QQQ) tracks the tech-focused NASDAQ 100. Then there’s the SPDR Dow Jones Industrial Average ETF (DIA), which tracks the Dow Jones Industrial Average.
So, what is short selling? Short selling, also known as “shorting,” means borrowing shares from your broker and selling them at a higher price with the hope of buying them back later at a lower price. That last part is called “covering your short position.” At that point, you’re basically returning the shares you borrowed from the broker.
So, instead of “buy low, sell high,” the short selling strategy is “borrow the shares, sell high, buy back low, and return the shares to your broker.” This can be done with index-tracking ETFs as a wager that they’ll follow the market down. It’s a bit complicated, which is one reason why I don’t recommend this strategy for beginners.
The other reason I don’t recommend it is that it’s very risky. In fact, it’s actually possible to lose more money than you have in your brokerage account. You could short sell an ETF, and the price could then go higher and higher—with no theoretical limit. After all, there’s a floor to stock prices ($0.00), but there’s no ceiling. The next thing you know, you’ll be required to buy the ETF shares back at higher and higher prices. It’s a dangerous situation that I wouldn’t want to happen to anybody.
Buying inverse index-tracking ETFs when the stock market falls
A safer strategy would be to avoid short selling altogether and instead buy an inverse index-tracking ETF. This is an ETF that goes in the opposite direction of a stock market index such as the S&P 500, NASDAQ 100, or Dow Jones Industrial Average.
As I explained, there’s a floor to stock and ETF prices. They could theoretically keep going up forever, but the lowest they can go is $0.00. You could lose all of your invested money in a worst-case scenario. However, at least you won’t lose more than you invested (not counting tax-related consequences).
That’s why I would consider this strategy to be the simplest way to place a bet against the stock market. All you’d need to do is buy shares of such an ETF and hope that the stock market crashes soon. Be aware, though, that inverse ETFs aren’t guaranteed to perfectly reflect the inverse of their corresponding indexes. Sometimes they have “tracking errors” you’d need to be aware of.
One popular inverse index-tracking ETF is the ProShares Short S&P 500 (SH), which attempts to move opposite the S&P 500. Another is the ProShares Short QQQ (PSQ), which claims to inversely track the NASDAQ 100. There’s also the ProShares Short Dow 30 (DOG), which strives to move in the opposite direction of the Dow Jones Industrial Average.
Buying volatility ETFs
A similar method of buying an inverse index-tracking ETF is to buy a volatility ETF. Volatility is basically a measure of the fear in the market. When the market goes down, fear rises. If you own a volatility ETF, you can profit from this increase in market fear.
It works both ways, though. When the market goes up, fear decreases. Volatility ETFs will decline in price when that happens. To put it another way, buying a volatility ETF means you’re betting that fear in the market will increase.
Note that volatility ETFs can have tracking errors. This means that they’re not guaranteed to perfectly reflect the amount of fear in the market. There may also be times when the stock market goes down and volatility ETFs also go down. I’ve seen this happen on occasion.
Volatility ETFs are known for moving wildly sometimes. I’ve seen them go up 10% or more in a single day. This can happen when the stock market is crashing and there’s a lot of fear. However, I’ve also seen volatility ETFs fall sharply. This is known to happen sometimes when the market goes up a lot.
Because they move so wildly sometimes, volatility ETFs aren’t recommended for beginners. However, just so you’re aware of them, some well-known options include the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), the ProShares Ultra VIX Short-Term Futures ETF (UVXY), and the VelocityShares Daily 2x VIX Short-Term ETN (TVIX).
Safety first when playing the market
There are other methods that involve options and futures, but that’s beyond the scope of this discussion. I’ve kept it as simple as possible and narrowed it down to three possible strategies for now. However, all three are still risky—and two are too dangerous to recommend.
Without a doubt, buying an inverse index-tracking ETF is the method I’d recommend for most people who want to profit when the stock market goes down. Still, if you’re unsure or hesitant, you don’t have to use any of these strategies. A safety-first policy will help prevent disaster as you strive to profit when the market goes south.