How to make money in a falling market

IMPORTANT NOTE as at 19th Sept. 2008 (maybe earlier date in US). Short selling in Financial stocks (UK and maybe US also) ais not allowed by order of the relevent Financial Authority. This includes CFDs, Spread Betting as well as stock trading. I am not sure about Options but as these are derivatives I doubt it. It is the individuals responsibilty to see that this rule is not broken. It appears to be a temporary measure at the moment.  

Apart from trying to find a sector that may do well in a recession or when most sectors are falling such as debt management, care homes, food manufacturing etc. there are a few other strategies that will do well whilst markets are falling. These are short selling stocks, going short using traded options or shorting the market using index futures.
These can all be high risk, dare I say very high risk so should not be undertaken lightly and unless you have the necessary knowledge.

Short selling stocks

This is fairly straightforward; instead of buying a share as your opening trade and selling to close your position, you effect the sale first and then buy back later to close.

The object is to sell at one price and then buy back when the price has fallen, thus making a profit.

A lot of stockbrokers will not let you go short stock, due to not having the resources to monitor the risk, strain on their capital requirement and usually a constraint from their clearing agents.
The way around this problem is through the use of a CFD, or Contract For Difference.

Risk

The normal risk of trading long (buying and then selling to close) is losing money. The maximum amount of money you can lose is 100% of your investment (cost of stock, SDRT and broker’s fee)
However if you are trading short your potential loss is, in theory unlimited. Let’s say you sell shares short at 100p per share. What is your potential loss? Your potential loss is the difference between 100p and infinity! Of course this cannot happen in practice but let’s say it is an oil exploration company that announces a major new find. What might the subsequent share price be? £5? £10? And you have got to buy them back.

Short selling through CFDs

More or less the same principal as short selling stocks, in fact the CFD provider sells the stock short on your behalf. You have to put up margin, perhaps 20% of the value of the trade and keep that 20% margin constant. If the shares go up, increasing your loss you would have to put up more margin.

Risk

The risk is the same as above but can be alleviated in two ways: The CFD provider has sophisticated methods of risk management and will monitor all their positions constantly. If your margin requirement is not maintained then they will quickly close your position. They will also allocate you with stop limits according to your cash deposits with them. There is a default stop loss level put in place when you trade. This can be adjusted by the client if he puts up more money. But remember these stop losses may not be guaranteed, rather dealt on a ‘best endeavours’ basis. Alternatively you can request a guaranteed stop loss, which does exactly what it says. Again this will cost you more. If you are contemplating using CFDs then all the above should be checked with the provider and thoroughly understood before trading.
Short selling through spread betting


Similar to CFDs in the fact that you trade on margin. I say trade but in fact it is not a trade, at least not on the stock market. As the name implies this is, in fact a bet. You are betting on the movement in a share price. Because of this any profits are not subject to Capital Gains Tax (CGT). One negative of spread betting is that the ‘prices’ do not mirror the prices quoted on the market. They are just a bit wider. Maybe something to look out for, especially in smaller priced shares.
Traded Options

There are many, many strategies using traded options but here I am just going to tell you the two basic trades for a bear market. They are buying PUT options and selling CALLS.

Buying PUTS

What this means is paying money for the right to sell to someone shares at a set price during a set period. Let’s say you pay 10% of a shares value for the right to sell those shares at today’s price. If the shares go down, as you hope, you exercise your right to sell them at the fixed price. As you do not have those shares you must buy them in the market, but, of course, you buy them cheaper thereby making your profit.

Selling CALLS

Also known as writing calls. This is where you sell someone the right to buy the shares from you at a set price. Now you take the money, say 10% of the value of the shares but for that you are passing control to the other party. It is his decision whether he buys the stock off you or not. You just have to sit and wait! So, how does this work. The market goes down as you expected. He will not call, or buy the shares off you at the fixed price because their value would be lower, he could buy them cheaper in the market. The option would expire and you would keep the 10%

Risk

Risk in buying PUTS; All that is at risk is the option money (the 10%). However high the stock goes you need do nothing, you are in control of the decision. So you just let the option expire worthless and lose the option money.

Not so when writing CALLS, however. Let’s see why the risk is so much higher. The share price goes up, against your prediction. The buyer of the CALLS rubs his hands with glee. He has bought the right to buy those shares off you at the fixed price and now they are going through the roof! Again the potential loss, your loss is limitless. If they are called off you you will have to buy them in the market at whatever price.

The way around this, of course is spread betting traded options, where those stop losses come in to play.

I have spoken in simple terms about shares. There are as many things you can short as go long, such as oil, gold, wheat but I will not go into those here although I will mention shorting an Index (or Indices) such as the FTSE100.

This can be done in the same way as shares as described above but also by dealing in Futures. As well as being traded in the futures market you can participate through spread betting. A futures contract is traded on margin and the margin requirements and stop loss arrangements can be similar to stocks and options. However, unlike traded options) a Futures contract will move more or less in line with the underlying index. There is none of the complexities of share options such as volatility, time value and intrinsic value.

So if you spread bet £10 a point on the FTSE future each point movement on the FTSE100 will make or lose you £10. Whereas on a`FTSE100 traded option one point movement on the index will not always relate to the option price.

This is a fascinating subject and if you are interested I strongly urge you to get some good books on the subject and read all about it.
One book I can recommend for options is Trading in Options by Geoffrey Chamberlain.