How would one profit from a share price falling, granted that they correctly predicted it would happen?
Say I had a hunch that a certain stock was going to fall next week, how could I effectively make a profit on this.
Personal Finance & Money Stack Exchange is a question and answer site for people who want to be financially literate. It only takes a minute to sign up.Sign up to join this community
The three normal ways to profit from falling stock prices are:
Short sale: Borrow someone else's shares. Sell at current price. Wait for price to fall. Buy back at lower price. Return shares to owner. This has unbounded upside risk should share price increase significantly.
Sell/write call options with strike price above current share price. If share price does not rise above the strike price, the calls will expire and you will keep the money made from selling them. If the calls are naked, the risk above the strike price plus premium received is the same as being short the stock.
Buy put options with a strike price lower than current price. When stock drops below strike price of put, either buy shares at new low price and exercise the option to sell at a high price, or sell the option. The most you can lose is the cost of the long puts.
All three of the above are risky, especially for a novice investor and are not recommended to anyone without significant experience and understanding of derivatives.
You can short sell shares, buy put options or write call options as noted above, but make sure you have stop loss orders in place if you are going long or short.
Another method you could use to also profit from a falling market is to buy bear ETFs (Exchange Traded Funds), you can use these to trade the market as a whole or to profit from falling sectors or whatever else might be covered by bear ETFs.
And if you are not in the US, you can trade CFDs (Contracts For Difference), which you can go both long and short in. But again remember to not overtrade (as CFDs use margin) and to use stop losses appropriately.
You can profit from a share price falling by what is known as shorting the stock. Effectively you borrow the stock from a broker willing to loan it to you at the current price then 'sell' it back to them when the price of the stock falls. The difference is yours to keep.
Be warned however this is a risky position to take as it now exposes you to theoretically infinite losses if the stock moves the other way. When you're 'long' a stock, you can only lose the money you spent on it.
Ways to benefit if a security is dropping:
1) Short the shares if they are borrowable and the borrow fee isn't huge. This requires a margin account. Borrow fees can be as low as 0.25 pct or crazy numbers like 50-75-100% per year. Buy them back for a profit if price drops. Buy them back for a loss if they rise.
2) Buy put options. To capture smaller moves, buy ITM puts. They will lose more than OTM puts if you are wrong. For leverage, buy OTM puts. If you get a big move, the ROI is higher than with ITM puts. If wrong, you will lose less (on a 1:1 basis). The delta of the option will tell you how much the option should gain (or lose) per point of stock movement. Delta is non linear and affected by the level of implied volatility so keep in mind that it's an approximation.
3) Sell/write covered calls. If they expire, you keep the money made from selling them. This is more of an income proposition and unless the calls are deep ITM, they will hedge the underlying poorly (small premium against large underlying drop). And as the stock drops, you may find yourself in a position where there is no strike price that you can write without locking in a loss.
(1) (short stock) is the only dangerous choice.
(2) (long puts) has limited risk.
(3) is an opportunity risk if the price rises and you are assigned and must sell the stock at the strike price (you don't participate in the upside).
If you want a global approach, you can buy inverse ETFs but they bear a similar risk to shorting.
Shorting is risky and should only be don by those who are experienced and who practice good risk management. While it is true that there are "theoretically infinite losses if the stock moves the other way", that's just not reality. No stock has ever gone to infinity and no big cap stock will ever do this. You manage a short position just as you manage a long position.