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Suppose there is an investment, such as a stock, which I currently own no units of. I predict this investment will soon drop in value. I have no reason to predict that the investment will bounce back shortly after it drops in value.

If I owned some units, I would want to sell them before the drop in value. If I expected the investment to suddenly increase in value, I would want to buy as many units as possible before that happens, and probably sell them right after. But none of these is the case.

Assuming my prediction is accurate, that is, the investment's value will drop significantly in the near future, is there a way I can profit from acting on this prediction?

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To expand on the comment made by @NateEldredge, you're looking to take a short position. A short position essentially functions as follows:

  • Borrow a share owned by someone else
  • Sell that share
  • Wait for the price to fall
  • Buy a share after the price falls
  • Return the share to the owner from which you borrowed.

Here's the rub: you have unlimited loss potential. Maybe you borrow a share and sell it at $10. Maybe in a month you still haven't closed the position and now the share is trading at $1,000. The share lender comes calling for their share and you have to close the position at $1,000 for a loss of $990. Now what if it was $1,000,000 per share, etc.

To avoid this unlimited loss risk, you can instead buy a put option contract. In this situation you buy a contract that will expire at some point in the future for the right to sell a share of stock for $x. You get to put that share on to someone else. If the underlying stock price were to instead rise above the put's exercise price, the put will expire worthless — but your loss is limited to the premium paid to acquire the put option contract.

There are all sorts of advanced options trades sometimes including taking a short or long position in a security. It's generally not advisable to undertake these sorts of trades until you're very comfortable with the mechanics of the contracts. It's definitely not advisable to take an unhedged short position, either by borrowing someone else's share(s) to sell or selling an option (when you sell the option you take the risk), because of the unlimited loss potential described above.

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    Many brokers also accept stop loss orders as a way of limiting risk on naked shorts. – Nick R Jun 28 '16 at 19:28
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    @NickR Of course it should be noted that if you shorted a stock at $10, put in a stop loss order at $12, then there was an overnight gap to $20, you'll be buying back those shares at $20 instead of $12. – pacoverflow Jun 28 '16 at 20:09
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    It's worth noting that with a put option, the amount of money at risk is considerably less, but your likelihood of making money is also lower, as you're not only expecting the price of the underlying security to fall; you're expecting it to fall by more than the cost of the option, within a specific time period, and getting that right is a lot trickier. – Mason Wheeler Jun 28 '16 at 20:36
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    Another hedge to a short position is to buy an out of the money call at wherever point you would normally place your stop. This protects against a gap up and depending on how much can you afford to lose can be a quite inexpensive form of "insurance" - of course as other comments pointed out, you'll need to either close out your positions or roll into a new call before it expires. – Michael Jun 28 '16 at 22:30
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    Infamous short loss from last year: zerohedge.com/news/2015-11-19/… – Chris Jun 29 '16 at 0:04
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Purchasing an option to sell the stock is probably the safest bet. This gives you reasonable leverage, and your risk is limited to the cost of the option.

Say the stock currently sells for $100 per share. You think it will drop to $80 per share in the next two weeks and the market thinks the price will be stable.

Now, consider an option to sell one share of that stock for $95 any time within the next two weeks. The market would consider that option nearly worthless, since in all likelihood, you would lose out by exercising it (since you could just sell the share on the market for a price expected to be higher than that). You might be able to acquire that option for $5.

Now, say you're right and within two weeks, the price drops to $80. Now you can purchase a share for $80, exercise the option to sell it for $95, and pocket $15. That would make you a $10 profit on a $5 investment.

If you're wrong, you just let the option lapse and are out $5. No problem.

In reality, you would buy a number of such options. And you wouldn't actually buy a share and exercise the option, you would just sell the option back to its issuer for $15.

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To summarize, there are three basic ways:

  1. You can buy a "put" option. For a small sum of money, you buy the right to sell the stock for some price at any time between now and some time in the future (usually between 30 and 90 days in the future). Right now, "F" (Ford Motor Company) is trading at 12.55. You can buy the right to sell it for 13.00 until July 8 for $0.66. Obviously, buying and exercising that put today would be an immediate loss of 21¢ (the 45¢ profit from the sale, less the 66¢ you paid for the option), but if it turns out tomorrow that F-150s cause testicular cancers and Ford stock drops to $8, that 66¢ option will bring you a $5 return. On the other hand, if the stock drifts up to $13.01, your option is worthless.
  2. You can write a "call" option. That means you agree to sell someone the stock (if he wants it) at some price. Right now, selling a call option for F at 13 would earn you 5¢, and if the stock goes down, or just fails to go as high as 13, you get to keep that nickel. If you're wrong, though, and Ford stock goes through the roof, well, since you don't actually own that stock you promised you'd sell (you are "naked" as they say) you have to come up with the difference out of your own pocket.
  3. You can make a short sale. You borrow, for a small premium, a share of stock and sell it at the current price of $12.55. At some point in the future though, the person you borrowed that stock from is going to want it back.

(3) is the truly dangerous one. If there is a lot of short interest in a stock, but for some reason the stock goes up, suddenly a lot of people will be scrambling to buy that stock to cover their short position -- which will drive the price up even further, making the problem worse. Pretty soon, a bunch of smart rich guys will be poor guys who are suddenly very aware that they aren't as smart as they thought they were. Eight years ago, such a "short squeeze", as it's called, made the price of VW quadruple in two days. You could hear the Heinies howl from Hamburg to Haldenwanger.

There are ways to protect yourself, of course. You can go short but also buy a call at a much higher price, thereby limiting your exposure, a strategy called a "straddle", but you also reduce your profit if you guessed right.

It comes down to, as it always does, do you want to eat well, or to sleep well?

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