Shorting the Stock Market

Most financial advisers will tell you to dollar cost average your investments especially retirement investments throughout your life. However, what you do with your investments is up to you and many folks are wary of the stock market given its multi-year rise, its all time high, and the winding down of QE from the Federal Reserve. I hope this article helps you understand how you can “short” the stock market without risking too much money, or how you can buy options to insure your long position in the stock market for this year.

For those that don’t know – if you short a stock you buy negative shares of the stock with the obligation to buy those shares back sometime in the future (unless the company goes bankrupt). Quite a few people now are advocating shorting the stock market, trying to time a large market correction. There are a few ways to in essence short the stock market – you can either buy some short positions in individual shares like Amazon or Twitter or any other stock that has a large P/E ratio (meaning the stock is overbought), or you can buy put options for those shares – which is buying an option to sell the stock at a certain amount in the future. Buying a put option is infinitely safer than buying an uncovered short position in a stock since your loss is limited to the premium paid for the option. You can also buy exchange traded funds (ETFs) that are managed funds that comprise a variety of short positions aimed at giving returns if the stock market falls.

One example of such exchange traded funds is DOG, which according to its description “seeks daily investment results that correspond to the inverse daily performance of the Dow Jones Industrial Average (DJIA)”. Such exchange traded funds do extremely well if the stock market falls, and might be a good way to “insure” your long stock positions. DOG went up 40% from May 2018 to late November during the financial meltdown.

A call option for a ETF like DOG could be profitable if you buy one with a good strike price. For example, DOG is currently trading at $26.10, there is a call option for 11/22/2014 strike price $28. The option is currently priced at $0.70 and each option is a bundle of 100 shares, so buying 1 option would cost $70. If DOG goes up 40% between now and November (like happened during the financial meltdown of 2008) the price will go up to $36.54 and your call option would be $8.54 above the strike price per share – which would be valued at $854, and after subtracting the premium of $70 you would have made a profit of $784. Your gross profit margin percentage would be 91.8%, versus the 28.6% profit margin you could get by simply buying a share of the ETF.

The last way to avoid stock market risk is of course to sell your stocks or if you have a 401k that only allows certain allocations to reallocate to a fixed income account or bond account. That being said, a market meltdown will also hit bonds.

*disclaimer I own a call option for DOG but do not have any short positions*

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