There’s a saying on Wall Street –- “the stock market takes the stairs up, and the elevator down.” Case in point: the recent COVID-19 crash.
Years of slow and steady gains were wiped away in early 2020 when the Dow Jones shed more than a third of its value in a single chaotic month, as investors reeled from the impact of the novel coronavirus pandemic.
It’s far from clear today that markets have stabilized; many analysts believe that they could go lower still. And with that in mind, now is an important time to learn shorting techniques.
These lucrative strategies can help you earn substantial profits in down markets like this one –- while protecting your bull market gains.
You’ve gotten off to a great start by subscribing to Wealth Daily -– a venerated financial news and education service with a strong track record of helping investors through times like this. And you’ve taken an even bigger step toward shorting mastery by claiming your copy of this exclusive report.
Below, we’ll be walking you through three of the most common shorting techniques –– conventional short-selling, put buying, and inverse ETF investing. We’ll explain how these.
techniques work, the basic strategy behind them, and how to execute them in your brokerage account.
Let’s start with the most basic shorting technique…
What Is It?
Conventional short-selling involves borrowing shares from a broker, immediately selling those shares, then buying them back when their price drops and returning them to the broker — pocketing the difference between the initial sale price and the purchase price.
For instance, say you wanted to short Centex Homes back in 2007 because you knew that the housing bubble was about to burst. You could have borrowed 1000 shares of CTX from your broker and sold them short for $60 a share. That would have put $60,000 into your account.
A few months later, as your thesis played out, you could have bought those same 1000 shares of CTX back as housing totally tanked - for as low as $18 a share. That would have cost you $18,000.
So your broker would get back the 1000 shares of CTX that you borrowed and you would get to keep the difference –– a cool $42,000 for your troubles.
Neat deal, huh? But it's not for everybody.
Short selling is risky because if the trade goes against you, your losses are unlimited. After all, CTX could have gone to $200 a share, costing you $200,000 to buy back –– a $140,000 loss. Ouch.
Moreover, short-sellers must establish a margin account on these transactions and pay interest –– as high as 8% –– on these sales, along with the real possibility of a margin call.
The Strategy Behind It
Many short selling strategies are drawn from technical analysis and involve waiting for a stock to break below a particular support level in a predictable way.
One popular strategy involves shorting a stock when its 50-day exponential moving average (EMA) drops below its 200-day EMA -– a signal of wavering momentum in a stock’s long-term price trajectory which is sometimes called a “death cross.”
Ford (NYSE: F) provided a good example of how this strategy can work in 2018. Its late-June death cross preceded a 30% decline in the company’s stock price over the following three months.
Other short sellers use fundamental valuation metrics such as price-to-earnings (P/E) ratios to determine when to get in and out of a short position.
As you can see, this also would have been an effective strategy in determining when to short Ford in 2018. Its (P/E) ratio spiked to an unusually high level just before its stock price collapsed.
Regardless of which indicators you use, make sure you have a solid thesis before selling any stock short.
After all, in most long positions, losses are capped at 100% –– the worst thing that can happen is the loss of your entire investment. But due to the nature of conventional short-selling, losses with this technique are potentially unlimited.
How to Set up Your Brokerage Account for It
Although it’s arguably the most straightforward way to build a short position, conventional short selling is one of the most complicated techniques to execute in a standard online brokerage account. It requires opening a margin account, after all.
Each brokerage has its own in-house margin requirements, so the process of setting up your account for conventional short-selling may vary depending on where you trade stocks.
You can find information about how to set up your account for conventional short selling with E-Trade here, with TD Ameritrade here, with Interactive Brokers here, with Fidelity here, with Schwab here, and with Vanguard here.
But if that’s too much set-up and too much risk for you, there’s a much easier-to-execute shorting strategy you should consider. It just takes a bit of getting used to...
What Is It?
As intimidating as they might sound at first, options are relatively simple investment vehicles that everyone should take advantage of. Simply put, owners of an options contract have purchased the right — but not the obligation — to buy (calls) or sell (puts) shares of a specific stock at a specific price for a set period of time.
If you buy a put contract, you have purchased the right to sell a set number of shares at a specific price. That right can be very valuable in the event that the market price of those shares falls.
Suppose, for instance, that XYZ Corporation stock trades at $100.00 per share, and that you’ve bought a block of 100 put contracts at a $90 strike price for, say, $5 each.
Now suppose that XYZ badly misses earnings estimates and that its share price drops to $70. Your contracts, which give you the right to sell 100 shares at the above-market price of $90 per share, would likely become a sought-after commodity. You could resell them for perhaps $10, $20, or even more.
The Strategy Behind It
In general, options trading strategy is an incredibly complex topic that merits its own investment newsletter. But building short positions with put options is actually quite simple.
One extremely easy option shorting technique involves buying a put on a company’s stock with a strike price near the stock’s current market price –– but with an expiration date after the expected decline in the stock.
To reuse the Ford example from the conventional short-selling section, a short investor might have bought puts on Ford back in early July 2018 with a strike price of $11 and an expiration in October 2018.
Those puts wouldn’t have been worth much in July. After all, they’d give the holder the right to sell Ford shares in October at a price roughly equal to what was then the market price –- not a very valuable right.
But come September, when Ford’s price had crashed below $8.50, the right to sell shares at $11 would have become quite valuable –– and thus so would have those put option contracts.
How to Set Up your Brokerage Account For It
As with margin accounts, each brokerage has its own internal requirements for options trading.
You can find information about how to set up your account for put buying with E-Trade here, with TD Ameritrade here, with Interactive Brokers here, with Fidelity here, with Schwab here, and with Vanguard here.
What’s not unique to each brokerage, however, is the system of exchange-traded option ticker symbols. These are quite a bit longer than stock ticker symbols, as they convey much more information. The formula for an option ticker symbol is as follows:
Root Symbol plus Expiration Year(yy) plus Expiration Month(mm) plus Expiration Day(dd) plus Call/Put Indicator (C or P) plus Strike Price Dollars plus Strike Price Fraction of Dollars (which can include decimals)
Thus, a put option on Alphabet (NASDAQ: GOOG) expiring in September with a strike price of $900 would have the symbol GOOG200918P00900000 –– where GOOG indicates the underlying stock symbol, 20 indicates the year 2020, 0918 indicates September 18, P indicates put and 00900000 means $900.
If this is still too complicated for your liking, don’t fret –– there’s an even simpler method of shorting available to investors today…
Inverse ETF Investing
What Is It?
Inverse exchange-traded funds make betting against the markets considerably less complicated because all you have to do is buy a fund — a transaction that everyone understands. And it doesn't require a margin account.
The best part though is this: Your potential losses are limited. That's because since you are long on the fund the worst it can possibly do is go to zero. And while that certainly isn't good, it is much better the limitless losses possible with a true short.
Inverse ETFs, however, are broad market bets that a particular sector or index is headed south. They seek investment results that correspond to the inverse (opposite) of the benchmark, or index, with which they are associated.
For example, the ProShares Short S&P500 ETF (NYSE: SH) is a fund that seeks results that correspond to the inverse of the performance of the S&P 500 Index. As the index drops, the SH rises. Simple enough.
But what also makes these funds unique is how they are constructed. They don't actually short stocks but trade in derivatives, such as futures and options to bet against the index.
That construction allows for leverage and the creation of what is known as an Ultrashort ETF.
Ultrashort ETFs can juice up those downside bets by providing as much as three times the inverse of the index it tracks. So when an index drops one point the gain for the ultrashort is three.
The ProShares UltraPro Short S&P500 ETF (NYSE: SPXU), for instance, provides three times the inverse of the NASDAQ-100. It's like the SH on steroids.
The Strategy Behind It
Be warned, the magic of leverage is as painful on the way down as it is good on the way up. Also, be aware that over most long periods of time, the U.S. stock market has moved in one direction: up. So overall, the market goes up more than it goes down.
Besides, leveraged ETFs aren’t built for buy-and-hold investors for a variety of reasons.
For one, they have higher annual expense ratios (0.9% on average) than most ETFs (0.44% on average), making them impractical long-holds from a cost perspective.
Also, the rapid sale of securities within inverse ETFs generates a lot of taxable events for shareholders throughout the year, making it especially annoying to hold inverse ETFs for a long time outside of a tax-advantaged account.
But investors who have a solid short-term investment thesis in a strongly trending market can get a lot of use out of inverse ETFs by buying them ahead of an anticipated decline in that market, and selling them when they believe that decline has hit its bottom.
For instance, an investor who foresaw the impact of the COVID-19 pandemic on the oil market - and shorted it three months ago by buying the ProShares UltraShort Bloomberg Crude Oil ETF (NYSE: SCO) –– would be sitting on a 273% profit today.
How to Set Up your Brokerage Account For It
Inverse ETF investing is by far the simplest shorting technique to implement. It requires no margin and no options trading; inverse ETFs are just equity funds which you buy and sell like any other.
To short the S&P 500 using the ProShares Short S&P500 ETF (NYSE: SH), for example, you’d open your short position by simply buying shares of SH –– and close your short position by selling them.
As you can see, there are a variety of ways you can bet against unstable markets like the current one. Each has its advantages –– but also its risks.
You’ve taken a fantastic first step toward maximizing those advantages and mitigating those risks by subscribing to Wealth Daily. But if you’re looking for more shorting guidance, check out Bull and Bust Report. Their subscribers are enjoying double-digit profits on almost a dozen open positions –– even during these crazy times. Click here to learn more.