When the stock market is plunging, or at least stagnant, it may make sense to move your assets out of equity markets and put them into bonds or even cash. These don’t offer much in the way of growth, but they are generally safer than stocks and can protect you from losses. However, under such circumstances, investors have an alternative to bonds or cash – one that not only protects you from market losses, but allows you to profit from them. That alternative is called shorting the market, and it can provide a great hedge against market losses or even let you make big bets on a coming crash. But like any speculative market play, it can burn investors who aren’t careful. Here’s what investors should know about shorting.
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What Is “Shorting the Market”?
Shorting the market is a trading strategy where you profit off short-sale positions based on the stock market as a whole. Short positions are the opposite of traditional, or long, positions. When you hear someone say, “Buy low and then sell high,” they are talking about taking a long position.
Whereas a long position profits when its underlying asset gains value, a short position profits when the underlying asset loses value. That’s because shorting the market starts with borrowing a security and selling it. If you have calculated correctly that the security will lose value, you then buy it back after a set period of time and return it to the party you borrowed it from. What you pay to buy it back is – if the price has moved in your favor – less than what you sold it for initially. The difference between the price you sold it for initially and the price you later bought it back for is your profit. Instead of buy low and then sell high, this is sell high and then buy low.
It is common for traders to take short positions on specific stocks and commodities that they think are overvalued and due for a fall. However, you can also take short positions against entire industries, and even the stock market as a whole.
Shorting the stock market has been all over the news lately. You may have heard about the “short-squeeze” that’s surrounded various hedge funds and Reddit’s WallStreetBets in January 2021. This Reddit community, upon hearing that several Wall Street hedge funds had shorted stocks such as Gamestop and AMC, began buying up these stocks and driving up the share prices. As a result, the hedge funds who had taken short positions were forced to take massive losses. Some even went bankrupt. Retail investors who bought in early enough were able to sell their shares at a massive markup, even if the stock prices have since come down significantly.
How Do You Short the Market?
There are three standard ways to short the stock market.
The first option, and by far the easiest for retail traders, is to buy what is known as an inverse fund. These are mutual funds and exchange-traded funds (ETFs) built to profit whenever the underlying index declines.
Many of these funds, typically known as bear funds, are indexed to the S&P 500. This means that they are built to track the movement of the S&P 500 as a whole. However, because they are inverse funds, they gain value when the stock market goes down, and lose value when the stock market goes up.
Bear funds are generally built around underlying short sales and counter-cyclical assets. They tend to drift more than standard index funds do, meaning that they won’t mirror the S&P 500’s activity quite as closely. However, because you have bought these assets, they also come with far less risk to the investor than engaging in a direct short sale.
A second option is to short sell an ETF. In this strategy you would take a short position on an ETF that is indexed to the S&P 500. You would choose ordinary index ETFs, not inverse ones. When the S&P 500 declines, a fund indexed to it will also decline and your short position will profit. You cannot short sell an ordinary mutual fund.
Finally, you can also take a “put” position on an S&P 500 option or futures contract. An options contract is, essentially, placing a bet on how the price of a given asset will change over time. Buying a put option gives you the right but not the obligation to sell a security at a certain price – the strike price – any time before a certain date. This means you can require whoever sold you the put option – the writer – to pay you the strike price for the stock at any point before the time expires. For example, say you borrow a share of stock and sell it for $100, and then that stock’s price declines to $75. You buy back a share of stock at the lower price and return it to the broker who lent it to you, netting $25.
The Risks of Short Sales
Buying an inverse fund comes with the ordinary risks of investment. If your fund declines, you can potentially lose the money you have invested.
However, taking a short position on any fund or stock, along with taking many put positions, comes with a far greater risk. Unlike with a long position, with a short position you can lose more money than you invested. In fact, under virtually any circumstances, losing money on a short sale means owing more money than you invested to begin with.
Consider the example above, where you borrowed a share and sold it for $100. Rather than having the share fall to $75, it rises to $125. Now you have to buy a share of this company for the higher price and return it to the lender, so you’re out $25.
There is no way to predict your losses on a short sale. Since there is no limit to how high a stock (or market) can climb, there is no way to cap your losses. This is a fundamental difference from traditional trading and it makes short sales very risky for the retail investor.
Bottom Line
Buying low and then selling high is not the only way to make money in the stock market. You can flip the sequence of those two moves – selling high and then buying low – in what is known as shorting the market. It’s a risky strategy, but it’s also an essential way that the market corrects itself. When assets get over-valued, traders can take short positions as a way of signaling that the underlying asset needs to have its price corrected. As we saw with stocks like Gamestop and AMC in January 2021, shorting can have broad implications in the market, creating huge losses for some and huge gains for others.
Tips for Investing
- Whether the market is going up or going down, the insights and counsel of a financial advisor can help you build a stronger portfolio. SmartAsset’s matching tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Whether you’re short selling or not, make sure you pay attention to taxes when you invest in the stock market. SmartAsset’s capital gains tax calculator shows how Uncle Sam impacts your gains.
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