Down Markets and the Fear of Shorting

Today's guest blog post couldn't come at a better time!! I asked Thierry Martin


Every time the market goes into a downtrend, I see many traders and
investors throw in the towel. They just can't keep their trading
skills working properly when the market goes into "reverse." This is
too bad, because these traders are losing out on trading opportunities
by getting out of the market when it is going down, or they trade
against the overall trend and lower their chances to make a profit.

One choice you have when you see a sustained downtrend, as we are
seeing currently, is to find a sector that is not following the
overall market. Even though most of the sectors or industries will
show the same down trend as the overall market there are always a
couple of sectors with rising trends. So if you really can't stomach
the idea of betting on a stock to go lower in value, then just find
the sector that is bucking the trend, scan for the best stocks in that
sector, do your research, whether it is fundamental, technical or
both, and trade in that area only. You won't have as big a palette to
choose stocks from, but at least you will be trading stocks that are
moving in the right direction if you insist on going long.

Another way to profit in a downtrend is to stop caring which way the
market is moving and make money by "shorting" stocks. For some reason,
many traders never get their minds around the concept of shorting and
so just stay away from it. If you are one of the traders who don't
understand shorting, here is a new way to look at it: When you short,
you are still buying low and selling high as you do when you are going
long. When you short a stock you are doing the selling high first, and
the buying low second. In other words, you are betting that the stock
is going down, so you sell it at the higher price first, then when it
(hopefully) drops in price, you buy it back to complete the trade. How
can you sell a stock before you buy it? Well, your broker will let you
borrow somebody else's stock to sell, with an obligation on your part
to replace it at whatever price it may cost you in the future to buy
it back. If you get to replace it at a lower price than you sold it
for, you get to keep the profits, and of course if you replace it a
higher price you lost on the trade.

So once you understand how shorting works, the only other skill you
need to develop is a way to overcome the psychological block you may
feel about betting on the negative. This is less of a problem with
Forex trading, because trades are always placed using pairs so when
one currency is going down the other one is going up, but with stocks
a lot of traders feel bad betting on a stock to fall. It is important
to overcome this resistance to betting on the negative because there
are huge profits to make by shorting stocks while the overall market
is collapsing.

A clever way to avoid the fear of shorting is to buy "puts" on stocks.
By buying an option to sell a stock at a future date, you get to bet
on the stock price dropping. When the option rises in value as the
stock drops in value, you can sell it just as you would sell a stock
that goes up in value. Since the leverage in options is quite
substantial, the profits you can make if the stock drops in value are
much higher than they are when you are just shorting. And you get to
make money by watching the instument you bought rise in value, instead
of hoping what you bought goes down in value as you do when you short
a stock outright.

Thierry Martin operates the popular stock trading forum & the new forex trading forum

3 thoughts on “Down Markets and the Fear of Shorting

  1. Buying puts is a good way to earn in a bear market.

    I just made some good (sand) coin on puts. I bought some puts on DAVE and DAVE promptly tanked and my puts were in the money almost from the start. I then dumped them the other day just as they were starting to reverse the lurch down. Even thought DAVE is a stock I have watched over the years, my timing in and out was pure luck (actually the out timing was somewhat dictated by the looming expiration of my puts).

    When trying to get your mind around puts think of the insurance policy you buy on your car. You believe the value of your car is going to tank because of a wreck, so you pay a premium and buy an insurance policy on your car that pays out up to the pre-wreck value on your car if you get into an accident.

    Some important points. Puts are options, you do not have to exercise the transaction, if you don't and the option contract expires on you, you lose your premium (if you don't wreck your car during a policy's term you lose your premium). As is noted however, you don't have to exercise the option you can just sell the contract, again an expired contract is worth 0.

    When considering the purchase of options do not forget the premium (price paid for the option) when figuring out the likelihood of the put going up!

    Most people are familiar with company granted incentive options, in those cases you generally do not have the ability to sell the options, you have to either buy the underlying stock or perform a same day trade, so get over the idea of having to same day trade to make money and even if your options are not in the money the contracts still have value.

  2. Trader’s Dream – A Bull Market Either Way

    Due to the short-selling restrictions in the stock markets, it is not uncommon for traders to have a difficult time finding profitable trades in a downward moving market. Although daytraders have tried to circumvent these barriers by using derivatives such as ‘bullets’ and the like, the associated costs are often burdensome. Equity traders are subsequently left with missed opportunities or very high transaction costs.In contrast, the Forex market has no restrictions on short selling. Since every transaction in the Forex market involves the buying of one currency and the simultaneous selling of another, it is a bull-market either way. For example, if you wanted to go long the EUR/USD, you would be buying the base currency, which is the EUR, and paying for it in terms of the counter currency, by selling the USD. Conversely, if you wanted to short the pair, you would be selling the base currency, which is the EUR, and paying for it in terms of the counter currency, by buying USD. In both examples, a currency was being bought; there is no negative connotation associated with short selling in the Forex market.

Comments are closed.