3 Ways to Profit When the Markets are Falling

Arrows up and down

08 Feb 3 Ways to Profit When the Markets are Falling

I remembered during the 2008 Global Financial Crisis, the markets were tanking and there was fear on the streets. During lunch one day with my regular lunch kakis, we were chatting about how much our company’s share price has fallen. I made a casual remark. I wondered out loud that it would be awesome if we could make money when the markets are falling, instead of just when it rises.

They laughed off my idea. It was crazy, when the market crashes, everything comes down together. Nothing you do can save you from the apocalypse. You would be lucky to come out of this unscathed, much less profit from it, they said.

For the longest time in my life, I believe that if someone tells me something cannot be done, it does not mean it cannot be done. It only means he or she does not know how to do it.

That night, I set out to figure out for myself how to make money when the market crashes. Over the years I have learnt and discovered more. Here are 3 ways to get you started.

We know that trying to pick stocks can be very frustrating. Skip that frustration, get 21 ideas to finding profitable stocks in an instant. 

1. Short Stocks.

We are very used to buying stocks. When prices increase, we would sell them and keep the profits. That is the natural order of things.

Short selling works in the opposite direction. The shortist will sell a stock he does not have. When price goes down, he will buy back the stock at a lower price. Instead of buying low and selling high, the process is reversed and it now becomes ‘sell high buy low’.

The principles are simple but the mechanism is a bit more complicated. When I sell a car for example, I am required to deliver the physical car to the buyer. It is the same with stocks, after selling, the stock has to be delivered to the buyer.

And since the seller does not own the stock to begin with, the only way he can fulfill his side of the deal is to borrow the required quantity. SGX has a lending pool where investors can find stocks available for borrowing.

Contracts for Differences

The other way to take short positions in stocks is via Contracts for Differences (CFD). Basically they allow you to enter into a trade and take a position, with the CFD provider underwriting the position.

So if you think that the STI has further room to fall, you could sell the STI ETF via CFD and be rewarded when the market goes the way you predicted. There is no need to borrow shares because it is a bet an arrangement between yourself and the broker.

The downside of shorting

Shorting has its disadvantages. For one, the charges are prohibitive. SGX charges six percent ‘interest’ per annum to provide you with shares to short. In other words, if you had shorted a stock and its prices does not change after a year, you would still have been down by six percent. This is excluding brokerage commissions.

Although CFD tend to be cheaper to buy and sell, they are just as costly to finance. As CFDs are margin instruments, the entire value of the trade is subjected to financing charges. Charges differ between brokers and between individual stocks. The very established blue chip counters tend to be cheaper to trade, while the more obscure ones can cost up to 8% per annum.

With CFDs, there is also counter party risk involved. There is little redress if the provider is to fold up. This was what happened to with MF Global in 2011

And finally, shorting stocks exposes you to an asymmetrical risk profile. If you had bought say Singtel at $4, your upside is unlimited provided Singtel continues to do well and the stock price continues to climb. Your downside is capped at $4; at most you lose your entire investment should the company goes bust.

On the other hand, if you had sold short Singtel at $4, the maximum you can hope to make is $4 and that is in the unlikely event that the company goes bankrupt. Yet, the price of Singtel could theoretically increase to $8, $12 or even $400. You stand to potential lose many times your initial investment.

2. Options. 

Think of options as contracts signed between yourself and another party. A call option gives you the right but not the obligation to buy the asset at a particular price at a specified time in the future. It sounds complicated but an actual example would clarify things.

Apple shares are trading at $94 now. I can purchase a call option that will allow me to buy Apple at $95 approximately six months down the road in July 2016. That option would cost me $7.

Screen shot 2016-02-08 at AM 08.58.59

From now till then, a few things can happen. Apple might rise to $120. I will then exercise my options and purchase it for $95. My profits will sit at $120-$95-$7 = $18 per share.

Apple could also drop to $$70. In that case, it is pointless for me to buy in at $95. I will simply let the options expire worthless. I would have lost $7, the price for which I paid for the option in the first place.

Along the way, the price of my option will fluctuate. When the price of the underlying increases, so too will the price of the call option. As the option gets closer to expiry, its value will decay. It is a delicate balancing act for option traders.

Buying a call option will allow an investor to partake in the market’s rise. Put options work in the opposite direction. Buying a put option allows you the right but not the obligation to sell a particular asset at a fixed price after a fixed interval.

Coming back to the same example, I could purchase a put that allows me to sell Apple shares at $95 in July. That put would cost a little bit more at $8. Of course there is the possibility that the put expires worthless when Apple shares rise. 

Screen shot 2016-02-08 at AM 09.06.13

Should the price of Apple fall to $70, my profits would be $95 – $8 – $70 = $17. While the price of the underlying has fallen by 30%, my trade would have made me double my initial investment of $8.

Options are complex derivatives. 

At first glance, buying put options seem like a good strategy. The downside is capped while the upside is seemingly unlimited.

In reality, options are expensive and complex instruments. Expensive because time decay causes the price of options to drop every single day. Expensive also because depending on the style of trading, commissions can be prohibitive.

Option pricing alone is dependent on many variables, not only the price of the underlying. As an investor, not only do we need to get the call on the market direction right, there is also the added element of timing.

It is an extremely taxing affair and the weekend investor would do well to stay away.

3. Inverse ETFs.

If the complexity of options gives you a headache, ETFs could just be the instrument for you. Unlike options, conventional ETFs are cheap and easy to buy and sell.

The majority of ETFs in the market tracks a benchmark. There are two ETFs that track the local markets, the Nikko AM STI ETF and SPRD STI ETF. For them, their aim is to replicate the STI. (We are such big advocates that we have even produced a comprehensive guide on them!)

Inverse ETFs are designed to do the exact opposite. Using different instruments in the back room, the managers create a fund that decreases in value when the market is bouyant, and rises when the market is rising. A 1% increase in the index sees a 1% decrease in the value of the ETF and vice versa. For the retail investor, purchasing an inverse ETF is the equivalent of shorting the benchmark it is tracking.

Some of the most established inverse ETFs include the Short S&P500 and the Short Russell2000 issued by Proshares. They track respectively the biggest and smallest companies listed in the US. In Singapore, the S&P500 Inverse Daily is traded on the SGX. You will be able to participate and profit from the decline of the US market directly via any local brokerage account.

To make things a little more interesting, there are also leveraged inverse ETFs. Instead of a corresponding rise or fall in price vis a vis the index, leveraged ETFs aim to replicate the market movement via a multiple of 2x or 3x. The Proshares Ultrapro Short S&P500 is one example. A 1% drop in the S&P500 index will see the fund gain approximately 3%.

Unlike traditional buy and hold investing as we would for regular ETFs, holding an inverse ETF for long periods of time will not work. Over the long run, equity markets tend to be on the uptrend. As such, inverse ETFs are best utilised as a short term market timing tool.

In Conclusion

There are many ways to profit from a falling market. Other than the 3 I have listed, there are also more exotic options like trading the volatility index (VIX), or using futures or even options on futures. For the punter looking for a thrill, it is an amusement park out there.

For the retail investor, I have taken a very simplistic approach in this article. In reality, financial markets are complex. We should not underestimate the intricacies involved.

Taking a short position involves market timing. It is a venture that requires not only knowledge of the tools but also a precise reading of the market. It is not an easy strategy but if done right, the payoffs can be huge.

Huat Ah!



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2 Comments
  • Tacomob
    Posted at 11:43h, 08 February Reply

    Hi Jon,
    Thank you for shedding some light on the possibilities to profit from falling markets.

    In regards to Inverse ETFs and especially leveraged Inverse ETFs it would be prudent for anyone to read up more.
    These two posts elaborate more on the mathematical issues with them:

    http://www.obliviousinvestor.com/are-inverse-etfs-a-good-way-to-reduce-risk/
    http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm

    As you mentioned Leveraged Inverse ETFs are mainly for the very short term only and thus very speculative. Regular Inverse ETFs could be useful when there is a strong bear trending market.

    I personally still do prefer deep Out-Of-The-Money Put Options on broad indexes to safeguard my downside risk from massive corrections.

    Just my two cents worth of input, Jon.

    • Jon
      Posted at 23:06h, 09 February Reply

      Thanks for the link Andy. Riverting stuff indeed.

      I am with you on the OTM puts. I first read about it many years ago from Gladwell who wrote about Nassim Taleb. http://gladwell.com/blowing-up/

      I like the idea of not only safeguarding, but also profiting from it.

      Some questions for you.

      1. How to you balance strike price and expiry? How far OTM is sufficient? Care to share your system for buying?
      2. Far OTM puts are cheap. To safeguard your portfolio, you would need to buy many contracts. Most of the brokers charge by contract, and this strategy ends up prohibitively expensive. Care to share which broker you used?

      Perhaps you could share more on TACOMOB!

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