How to Profit From Market Declines

Falling stock prices are not normally a positive development for investors. But there are exceptions: Some investment vehicles enable you to achieve returns when prices drop. In this guide, moneyland.ch introduces you to the various solutions for profiting from market declines. 

1. Short selling

When you short sell, you borrow an asset from a lender and then immediately sell the borrowed asset. The asset could be bonds or shares in a stock, for example. At the end of the loan term, you must return the borrowed asset to the lender.

The goal of short selling is to buy back the asset at a price lower than the one you got when you borrowed and sold it. You then return the borrowed assets to the lender. The difference between the higher price you receive when you sell the borrowed asset and the lower price you pay to buy it back ahead of returning it makes up your return on the investment. The further the price of the asset sinks during the loan term, the bigger your return will be.

On the other hand, if the price of the asset goes up over the loan term, then you will make a loss. The price you will have to pay to rebuy the asset in order to return it to the lender will be higher than the price you got when you borrowed and sold it. Depending on how prices develop. Theoretically, there is no limit on the losses that can be incurred because there is no roof on how far up the price of an asset can go.

Only a few Swiss stockbrokers offer short selling. The stockbroker places a sell order for securities that you do not own. You pay interest on the borrowed securities, and these interest charges detract from your returns. Because of the high risk, short selling is not advisable for inexperienced investors, as it is essentially betting on future price developments.

2. Short ETFs

Exchange-traded funds (ETFs) offer a more accessible and uncomplicated way to benefit from falling prices. ETFs that gain when prices fall are known as short ETFs or inverse ETFs. Typically, these ETFs replicate special sub-indexes that, in turn, inversely mirror the performance of an underlying stock or bond index. What that means is that if a stock index climbs by 0.5 percent, its inverse sub-index falls by 0.5 percent – and with it the performance of the short ETF that tracks it. On the other hand, if the main stock index goes down, the short ETF will gain value. In other words, the value of the ETF always moves in the exact opposite direction as the value of the underlying index.  

There are also leveraged ETFs that multiply the gains and losses of a short position by a certain factor. Example: A short ETF with a leverage factor that doubles performance will gain one percent of value if the underlying index falls by 0.5 percent. On the flip side, any losses in value will also be multiplied by two. 

While regular long ETFs that benefit from climbing prices are generally recommended for long investment terms, that is not the case with short ETFs. Historically, well diversified stock ETFs that profit from price gains have normally delivered positive performance over long terms. That means short ETFs which perform the opposite are often not well-suited to long investment terms. Nearly all short ETFs have seen negative performance over long terms. Because of that, short ETFs are primarily suitable for short-term speculation, as long as you are aware of the risk of losing money.  

Alternatively, short ETFs can also be used as part of a hedging strategy. You can invest part of your wealth into short ETFs in order to balance losses in the rest of your portfolio.

3. Put warrants and put options

Put warrants and put options give you the right to sell an underlying asset for a predetermined price during a certain timeframe. In order to make a return, the actual price of the underlying asset at the end of the term must be lower than the price that you get for it, as per the sell price defined in the put warrant. Investors who use put warrants normally hope that the price of the underlying asset will go down. The opposite of a put warrant is a call warrant.

Examples of underlying assets commonly used for put warrants and put options include specific stocks, whole stock market indexes, and commodities. Using put warrants and put options requires a high risk capacity and a thorough understanding of the underlying asset – and even then, there is no way to predict how markets will develop. Warrants and options are not dissimilar from betting, and inexperienced investors will generally do best to steer clear of them. If you are interested in using put warrants and put options, make sure to keep the high risk of loss in mind.

Not all Swiss stockbrokers let you use options or warrants. You can find out which stockbrokers offer these instruments by going to the Swiss stockbroker comparison and filtering the results using the options and warrants filters in the “Specialized asset types” section. 

4. Short mini futures

A future is a contract that obliges an investor to buy or sell a specific underlying asset for a certain price on a certain date.

A mini future is a type of future contract. It is a leveraged security that you can use to speculate on developments in the price of an underlying asset.

Mini futures can be long, meaning you profit from climbing prices, or short, meaning you profit from sinking prices. The short version is the one that can be used to profit from market losses.

Unlike regular futures, mini futures do not have fixed expiry dates. Instead, they come with a built-in stop loss threshold that triggers the redemption of the mini future. The mini future is automatically redeemed when the price of the underlying asset reaches a predetermined limit.

Mini futures are transparent, and the stop loss threshold limits the potential losses. But if you are interested in using a mini future, you should get informed about the leverage factor used. Leverage amplifies any changes in the price of the underlying asset, which amplifies the potential losses.

5. Contracts for difference

Contracts for difference (CFDs) can also be used to speculate on price developments without having to actually own the underlying asset. CFDs use leverage, so you only need to cover a part of the position yourself. The CFD must be collateralized by a margin. The leverage enables you to gain substantial returns within short period of time, but the same applies to losses as well. 

Because losses are amplified by leverage, CFDs are not really suitable for inexperienced investors. If you want to use CFDs, you should make sure never to invest money in them that you cannot easily afford to lose. It is also important to pay attention to the fees charged, which are relatively high.

To find out which stockbrokers offer CFDs, just select the CFDs filter under “Specialized asset types” in the Swiss stockbroker comparison on moneyland.ch.

Disclaimer: This article is provided for informative purposes only, and should not be considered as investment advice. The publisher does not accept any liability in connection with this publication.

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