Market Downturn: Three Ways to Short the Market

Investors often look for ways to hedge against or capitalize on stock market downturns. In some cases, the goal may be to do a little of both: attempt to hedge existing positions while opening new positions to seek profit from a declining stock market.

Whether the goal is to protect against or profit from a bearish turn, one of the most direct approaches is to short stock or the broader market. This strategy applies the "buy low, sell high" principle—just in reverse.

There are many ways to potentially profit from a falling market. Some trading strategies are relatively simple, while others can be quite complex. Some come with limited risks, while others may expose traders to extreme risks and unlimited losses. For starters, here are three ways to initiate a short position in the market using stocks, options, and futures.

Note: To initiate a short position, each approach requires the appropriate approved margin account for stocks, options, and futures trading.

Risk: Unlimited potential losses because there is technically no limit to how far a stock can rise

Aim: To seek profit from share price declines

Here's a hypothetical scenario: Suppose a trader senses weakness in stock ZYX; its overall fundamentals appear unhealthy, and its earnings capacity seems weak. The trader is anticipating a price decline, and they aim to generate a positive return when the stock price drops.

Stock ZYX is trading at $50 per share, but the trader thinks it's worth much less than its current valuation. They decide to short 100 shares, a total net position of $5,000. Then ZYX share price falls to $35 per share, and the trader "buys to cover" (buy back or repurchase) 100 shares at that price. Essentially, they bought 100 shares at a lower price (at $35) and sold them for a higher price (at $50), but they did it in reverse order. Their profit before commissions, fees, margin interest, or other payments, such as dividends (should they apply), would be $15 per share or $1,500 (15 x 100 shares).

Now, if the stock price of ZYX had moved in the opposite direction by the same amount—if its stock price had risen instead of fallen—the trader would lose $1,500 (more if they consider the commissions, fees, and other applicable costs). Before initiating a short sale, especially for beginners, it's important to understand the basics and risks of short selling.

Always keep in mind that short selling can expose traders to unlimited losses because a stock's price can technically rise indefinitely after it's been shorted. Traders may also be exposed to margin calls if a stock's price rises substantially, and shorting stocks involves borrowing costs and fees. Read this article to learn more about short selling risks.

What if a trader's aim isn't to profit from a stock's price decline but to attempt to preserve profits or mitigate losses on their current stock position? Can they place a direct hedge to protect their stocks? The answer is no; traders can't place a direct one-to-one short hedge on the same stock.

Essentially, brokerages typically don't allow traders to be long and short the same stock at the same time. However, in some cases, traders attempt to hedge their position by short selling a highly correlated stock, sector-based exchange-traded fund (ETF), or index fund—although correlations aren't always stable, and stock, sector, and index prices may diverge. This isn't a direct hedge, but in some cases, assuming continuing correlation, this trading strategy may help protect some gains rather than liquidating current stock positions.

Risk: Limited to the premium paid if the trader holds a long position on an options contract (until the contract expires)

Aim: To seek profit from share price declines

One way to potentially benefit from a stock's price decline would be to buy a put option, which gives the buyer the right, but not the obligation, to sell the stock at a predetermined price (the "strike" price) on or before a specific date (the expiration date).

When it comes to gaining short-term exposure on a stock, in contrast to a straightforward short sale that exposes traders to unlimited losses, the risk of buying a put is typically limited to the price—the "premium"—paid for it. If the option is out of the money—the market price of the stock is above the strike price—at expiration, the put option will expire worthless and 100% of the premium paid is lost.

If the stock price suddenly drops before expiration, the premium will likely increase in value, and the put option could potentially be sold for a profit. Note, however, there is no guarantee the premium will increase even if the stock price falls because other factors—such as time and volatility—affect options prices as well.

While purchasing a put may appear to be a relatively simple transaction, options contracts aren't simple instruments. There's a lot that goes into the mechanics of options trading and options pricing. Before trading options, it's important to understand the fundamentals. For example, holding an options position until expiration can have unintended consequences. If a put option is in the money—the stock price is below the strike price—by even $0.01 at expiration, the put may be automatically exercised, resulting in the sale of the underlying shares at the strike price. Investors who don't own sufficient shares to cover this sale—or whose accounts can't support the resulting short position—may find that their brokerage will take action before expiration, closing the position or declining to exercise the contract.

Although complex, once traders are familiar with the options trading mechanics, they may uncover new trading strategies for when to forecast a downtrend in the market.

Risk: Unlimited losses if uncovered because there is technically no limit to an index or commodity's upside

Aim: To seek profit from a market decline or to hedge a portfolio of equities

Short selling futures involves some different rules. However, similar to selling stock short, traders can sell (short trade) a futures contract to attempt to profit from an anticipated price decline of an index, commodity, or currency. Because futures include "equity" indexes, such as the S&P 500^®, Dow Jones Industrial Average^®, and Nasdaq-100^®, traders can also short index funds to hedge their equity positions, as long as the number of short futures contracts matches the size of the equity positions, and the index accurately reflects the exact composition and weighting of the stocks within the portfolio, which is extremely difficult and uncommon.

Bear in mind, futures trading is risky and is not for every investor or trader. Futures are highly leveraged instruments, which means futures can initially, be capital-efficient but also that it takes very little money to gain a lot of exposure…and things can move quickly. Profits and losses are amplified. When trading in a margin account and using leverage that exceeds what's typically available for stocks, traders are responsible for instruments where the total value can exceed the amount of capital in their account, which can trigger a margin call. If not careful, traders can lose more money than they have. Keep in mind, margin with futures is much different than with stocks in many other ways as well.

Futures margin, also known as a "performance bond," is the amount of money you are required to deposit in your futures account to establish and maintain a futures position. Futures margin is not a loan. If at any given time the funds in your account drop below the minimum regulatory requirement, or "house" margin requirements, you may be required to immediately deposit additional funds to maintain your position, or your position may be liquidated at a loss. You will be liable for any resulting debits. Charles Schwab Futures and Forex LLC may increase its "house" margin requirements at any time and is not required to provide you with advance notice of such requirement changes or liquidations initiated by Schwab. You are not entitled to an extension of time on any type of margin call.

Markets run in cycles—sometimes up; sometimes down. The good news is that there are tools available to investors who choose to try to take advantage of, or protect themselves from, the market's downside. For traders interested in short selling strategies, it's important to understand the unlimited risk as well as the potential benefits.