How To Make Money In A Declining Market

You don’t need the stock market to go up to make money.  There are a number of ways that you can bet on an individual stock or the stock market as a whole to go down.  While this is a speculative strategy (as opposed to an investment strategy) it can provide a useful hedge if you have other long positions, or it can be a great way to make money when conditions are not favorable for a bull market.

When you are betting on an asset to decline in value, your position is known as a “short position“.  You may also see a trader who has a “short position” referred to as “being short” or “shorting”.  The most common ways to do this are by selling a stock short, by purchasing Put Options, by writing Call options, or by purchasing a Put binary option.

Ways To Profit From Short Positions

Purchasing A Put Binary Option

This is perhaps the easiest way for the average trader to take a short position.  A binary option is extremely simple (it pays out a pre-set amount if the trade is in the money, or expires worthless if the trade is out of the money).  Binary option accounts are easy to open, can be funded with a credit card, and do not require any special “margin privileges” like a traditional brokerage account that is option eligible.

High Risk High Reward

The trader takes a short position by purchasing a Put option contract and entering the dollar amount that they want to risk on the trade.  The “strike price” is determined by the price of the security at the moment the trade is entered.  The trade has a pre-set payout amount (usually between 60% and 90% of the amount risked).  If the option expires in the money, the trader wins their money back plus the payout percentage designated for the trade.  It does not matter how far in the money the option contract expires, the payout is always the same.  If the trade expires out of the money, the trader loses 100% of the amount that they risked.  In this way a trader can potentially make a lot of money from their short position, but they also will lose their entire position if it expires out of the money.

By using binary options, a trader can purchase put options for different time frames to place a bet that will pay if an asset declines in value.  This is a viable way for an average trader to profit from a stock, a market, or other assets falling in price.  There are various lengths of time available for binary option trades, usually ranging from 1 minute up to a period of a month or months.

Selling a Stock Short

This is the most common way that traders and investors, and especially day traders, can profit from a decline in prices.  A short sale involves selling a quantity of an asset (usually a stock) that the trader does not actually own.  The trader will sell at the current market price to the open market, and their brokerage will provide the shares to the purchasing party.  The trader is effectively being loaned the shares from the brokerage.

The trader’s account is credited with the value of the sale.  The trader is usually charged interest from the brokerage daily for the shares that are loaned to the trader.

When the trader decides to close the position, they purchase the shares back from the open market.  If the price of the security has fallen, the trader will purchase the shares back (to payback the loaned shares to the brokerage) for less than what they were sold for.  The trader can then keep the difference between the price it was sold for and the price it was bought back for.

Limitation On Profits And High Potential Risk

The highest amount of money that a trader can make from selling a security short is 100%.  A 100% profit would be realized if a security becomes completely worthless (the trader would not need to pay back the loaned shares to the brokerage because they have no value). Most assets which are shorted do not go to a price of 0 though.  In fact a decline in price of 20% for the most commonly traded securities would be considered significant.

It is important to note that if a position is out of the money when it is closed, the trader does not need to necessarily lose a lot of money.  A position which is closed out for a slightly higher purchase price than the sale price, for instance, will result in a very small percentage loss.

That being said, there is no maximum to the amount of risk that a trader is exposed to.  While their maximum return is 100%, the price of a security may double, triple, quadruple, or even go up higher in price.  While brokerages have risk controls in place in the form of “margin calls”, this is not a perfect system and it does not necessarily limit the risk effectively.  If for instance a security closed one day below a level which would result in a margin call, and opened the next day significantly above the price which would incur a margin call, the trader is responsible for paying the brokerage any losses, without limit.

Selling Short Takes More Capital

Because a short sale of a security typically provides the lowest expected return compared to the other ways discussed here to profit from price declines, it takes the most capital on the trader’s part to make money.  Short selling can also only happen in a margin approved account, which has minimum balance requirements.  While many day traders do engage in short selling, and some are very profitable from it, there are limitations and benefits unique to this form of short position.  It is important for every trader to understand this completely before choosing their method of taking a short position.

Purchasing A Put Option (or Writing a Call Option) Using Traditional Options

A traditional stock option works by giving the owner the right to either buy (a Call option) or sell (a Put option) a security at a future date, for a specified price.  The option has a value because it provides this right to the owner at a future date (and prices may change between the purchase time and that future date), and it may have a value because it is either above or below the strike price when the option contract is purchased.

Purchasing a Put Option

If a trader owns a Put option, it gives that trader the right to sell shares of that particular stock to the option writer for a specific price on a specific date.  If the price is below the strike price, the trader will execute the option.  This means that they will buy shares at the market price, and sell them for the higher agreed upon strike price.  By owning a Put option the trader is making a bet that the price will decline, and that they will be able to purchase the shares on the open market for below the strike price (which the option writer is obligated to pay).

Returns are Potentially High and Risk is Capped

The benefit of a Put stock option is that they rewards are potentially very high, the highest of each of these methods.  A trader has the ability to make multiple times the money that they purchase the option for.  If the option expires out of the money, the option expires worthless, capping the risk to the trader at the amount they spend on the option contract(s).  Some view purchasing traditional stock options as the most beneficial risk/reward profile of any type of position, for trading purposes.  The caveat is that while the risk is capped, an option that expires even slightly out of the money has no value.  An option that expires slightly in the money will have a small value, so while the upside has a lot of potential, the expected return may not be high enough to compensate a trader for the risk of losing the entire trade amount.

Option Decay

Every option has a time value, otherwise known as Theta.  This is the value in the amount of time left between when an option is purchased, and when it will expire.  Time has value because the price of a stock can move over time.  The more time remaining, the more potential a stock has to move further into a profitable position for the option.  Even if the price of a stock or underlying security doesn’t move, the time until the option expires is constantly reducing.  As time passes, the time value of the option lessens.  This reducing time value is known as option decay.

Writing a Call Option

A trader can also profit from a decline in an assets value by writing Call options.  The trader sells the call options that they write on the open market, and if the price drops below the strike price, the trader will keep 100% of the money he earned by selling the options. If the option is executed in the money, the writer will be obligated to sell shares to the option owner at below market value prices, potentially resulting in a loss on the position.

No Cap On Risk

Because the price of a stock hypothetically has no limit to how high it can rise, the potential exists for very large losses when writing Call options.  As an example of how writing a Call option can turn out especially poorly, let’s say a trader writes a Call option (100 shares) for stock XYZ at a strike of $50.  Let’s say that the trader sells this option for $2 (taking in $200 of revenue).  If the price of the stock rises to $60 when the option is exercised, the trader must sell the owner of the option 100 shares at $50.  Because it costs $60 per share to acquire the shares, the trader will lose $8 per share ($10 a share on the price difference minus the $2 a share in revenues from writing the option).  This position loses $800, and it only had a maximum potential gain of $200.  Writing options can result in unfavorable risk/reward profiles in some circumstances, and traders should have extensive option knowledge before writing any options of their own.

The Best Method Depends Upon the Trader

There is no “best” method for profiting on a decline in prices.  There are unique benefits and risks to each style.  We use Binary Options because there is a high payout no matter how far in the money the option contract expires.  This allows us to precisely control our risk/reward profile.  It is also well suited to traders who do not want to put up substantial amounts of capital (as the other methods require).

The highest potential payout is using traditional Put options, but there is option decay, and an option that is executed a little bit in the money will only provide a small return to the owner (who also took a significant risk by purchasing the option and possibly losing 100%).

It is important for every trader to understand the workings of each type of short position, and to thoroughly understand their chosen method.  For simplicity and for the predictable payouts on all winning trades, we use binary options.  If you would like to become a binary options trader and you need to open a binary option account of your own please sign up for an account today.

Daniel Major

B.S. Degree in Economics and Finance. Professional day trader. Live and work in Manhattan, NY, NY.

Page Updated: February 10, 2015

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