Posted September 19, 2022
By Zach Scheidt
Is it wrong to profit from falling stocks?
Years ago at a family gathering, I let it slip that my hedge fund had a bearish play on one of the major banks.
This was during the financial crisis, and bearish positions on banks helped me hedge my clients’ risks to keep them from losing money.
My mother-in-law was incredulous.
"How could you profit from such a terrible situation?"
At the time, I didn't get into the dynamics of hedging, risk management, or the stiff competition in capital markets.
But it's an important concept for us to cover here — especially as you protect the value of your retirement in a bear market environment.
So let's jump in.
Profiting From Bear Markets: Good or Bad?
Before I share my opinion, I'd love to hear what you think. Do you think it’s wrong to profit from a bear market or a specific stock trading lower? Send me an email!
Today, I'll share my quick perspective on the ethics of making bear market trades. We'll also cover the best way I know to profit from falling stocks (in case you decide this strategy is right for you.)
Here's my position….
It's up to you to protect the savings you've worked so hard to build.
More importantly, the market is going to do what it will regardless of whether you're positioned for stocks to move up or down.
Your decision to profit from a stock falling won’t affect anyone else. Stock (and market) prices will eventually follow the true value of the companies (or economy) behind them.
So if you're not changing the outcome by betting that a stock will go lower, I think you should consider investing in a way that will help protect your wealth.
Think about it this way: If you lose money because stocks are trading lower, you can't expect anyone to come to your aid and give you back the money you lost.
So if you bear full responsibility for the gains (and the losses) that come from your investments, you should be free to make decisions that grow your wealth in both good times and bad.
Entire books have been written on the concept of capital allocation.
The logic behind this concept is that companies that generate profits should get your investment capital.
That way the companies can use the money to grow their business, hire more workers, produce products and services that support the economy, and generate profits for investors.
That's how the system is supposed to work. And if a company doesn't fulfill these objectives, it doesn't deserve your investment capital and should trade lower.
So unless you're intentionally manipulating the market, I believe you have a right — and even a responsibility — to profit from falling stocks during a bear market.
So now the question is… how do you do it safely and effectively?
Put Contracts Can Give You an Edge
One of the best ways to profit from falling stocks is to buy put option contracts on stocks you expect to fall.
If you're bearish on the broad market, you can also do this for tickers like SPY (which covers the S&P 500) or QQQ (which covers the Nasdaq 100).
Some people even use this strategy to hedge positions they want to hang on to.
For instance, you might hold a basket of high-quality stocks you want to own long-term and also buy a SPY put contract, which will increase in value if the market trades lower.
That way, gains on your put contract can offset potential losses from your long-term investments. But you can still hold those positions if you expect them to rebound in time.
So how do put contracts work?
Well when you buy a put contract, you're buying the right to sell 100 shares of stock at a particular price.
For instance, a ZM October 21 $80 put contract allows you to sell shares of Zoom Video (ZM) at $80 per share any time between now and October 21.
[Editor's Note: This is an example of how a trade could work, not a recommendation to buy put contracts for ZM]
As I write this, shares of ZM are trading near $77. So your right to sell the stock at $80 would be worth at least $3 per share.
After all, if you could buy shares of ZM today at $77 and then sell them at $80 (per the terms of your put contract), you would walk away with a $3 profit per share.
Basically, the lower ZM trades, the more this contract is worth. If ZM were to hit $50, the put contracts would be worth at least$30 per share.
See how these contracts can help you profit in a bear market?
Some Words of Caution
While I like the idea of buying put contracts in a bear market, it's important to understand the risks that come with it.
First, you need to understand that put contracts have a limited time frame.
Every put contract expires on a certain date. After that, the contract is void and disappears from your account.
You'll wind up paying more for a contract that has more time until expiration. And contracts that expire in a short period of time are typically cheaper.
But as you get closer to the expiration date, prices for put contracts tend to move lower unless the stock has a significant drop.
So timing is important with this strategy.
The other important thing to remember is that you can lose all the money you invest in a put contract.
Unlike a stock that will almost always have some value, put contracts can go to zero.
In the example above, if ZM trades above $80 when the contract expires in October, the contract will be worthless. Any money you invested in the put will be gone.
Fortunately, you don't have to invest a lot in put contracts to help protect your investments or profit from a bear market.
So if you decide to use this strategy, keep your positions small and don't risk money you can't afford to lose.