With the extreme volatility of the S&P 500’s 12.1% 2022 correction, many investors are worried about where the stock market is headed next.
For traders that believe the recent dip is merely the beginning of a much larger downturn, here are some potential ways to profit from a market downturn.
Short Sell Individual Stocks
There are two inherent benefits to owning shares of stock.
One is that the market, volatile as it may be, has a general upward trend over time because of the general growth of the economy. The other advantage to owning shares of stock is that the maximum risk is capped at a 100% loss, while the reward is potentially limitless.
When short selling a stock, these two advantages are flipped to disadvantages.
The best-case scenario, improbable as it may be, would be a 100-percent gain from short-selling a stock that eventually goes to zero. However, if the share price of a shorted stock doubles or triples, losses can amount to multiples of the size of the initial short position.
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Because of the nature of their business models, the bottom lines of online brokerages such as Charles Schwab Corp (NYSE:SCHW), Robinhood Markets Inc (NASDAQ:HOOD) and Interactive Brokers Group, Inc. (NASDAQ:IBKR) tend to grow and shrink right along with the overall market, so these stocks might make good candidates for short sale during a pullback.
Buy Put Options
If the idea of capping your gains at 100% while still allowing for the possibility of unlimited losses does not seem appealing, another approach is to buy put options. Put options limit losses to 100% while allowing gains of much greater than 100%.
The disadvantage of buying put options is that timing is critical. Not only does the price of the underlying stock need to fall for a put option to be profitable, but it must also fall before the put’s expiration date. The further into the future the option expiration date is, the more expensive the time-related option premium.
Buy Precious Metals
One indirect way to bet against the market is to bet on something that investors tend to flock to when they are scared: gold. One of the easiest ways to invest in gold without needing a treasure chest buried in the backyard is to buy shares of the SPDR Gold Trust (NYSE:GLD).
Any time there is economic uncertainty, the price of gold tends to spike because investors view gold as something that holds intrinsic value. However, the problem with betting on a rise in gold prices during a market downturn is that the inverse correlation between gold prices and the stock market is very loose. In fact, sometimes there is even a positive correlation between the S&P 500 and the price of gold.
Buy An Inverse ETF
Inverse ETFs are funds comprised of stocks and derivatives that are intended to trade inversely to a particular target. Many inverse ETFs are meant to trade inversely to the broad market, such as ProShares Short S&P 500 (NYSE:SH).
The advantages to owning an inverse ETF include diversification, no margin requirement, no time constraints or time premiums, and a correlation to the overall market that is nearly exactly inverse. However, even these inverse ETFs do not provide perfect inverse correlation, and the imperfect correlation can compound over time.
Although each choice has its advantages and disadvantages, investors that believe the worst is yet to come for the stock market certainly have plenty of choices for betting on further downside.
Original publication: 2014.