Generally when the stock market goes up, traders, investors and even brokers rejoice. Looking at the mood at such times, it would seem as if the markets will move only in one direction – upwards. Political uncertainty, deterioration in economic conditions, inflation or scandal – any one of these is sufficient to prick the balloon of euphoria. In no time at all, there is widespread panic.
But a falling market is not the end of the world. It is not only a bull market which offers opportunities to make profits. Shrewd traders and investors are active in a bear market as well as they know how to profit from falling stocks.
One who has a fair knowledge of the stock market can benefit from falling stocks in various ways. He can choose a suitable method depending on his risk appetite.
In the Cash Market
Trading in Own Stocks:
A person who has made investments in the stock market for the long term would not want to exit these stocks even in a falling market as he is confident that this situation will change. At the same time, he does not want to miss the opportunity to make money in this market upheaval. When the stocks are falling, he can trade in his own stocks. If he is confident that the prices of the scrips which he is holding will come down, he can sell them and buy them back on the same day at a lower rate or wait for a drastic fall in prices to buy them back. Either way he will profit from trading, bringing down the cost of his stocks.
When stocks are falling, a day trader can sell stocks he does not own, provided he buy them back before the end of the day. So his short positions are squared off on the same day and he does not carry forward any position.
In the Futures Market
For professional traders, falling stocks do not pose a problem at all. If they have the ability to take risks and capacity to make margin payments, they can easily go short in the futures market and profit from the fall in prices. If people who own the stock go short in the futures market, it is called a covered short. If the short position is taken without a corresponding long position in the cash market, then it is called a naked short. This can be very risky.
In the Options Market
An option is a contract in which the buyer gets the right but not the obligation to buy or sell a particular scrip or index at a specified price – also called the strike price- on or by a specific date. A ‘call option’ gives the buyer right to buy, a particular scrip whereas a ‘put option’ gives the right to sell a particular scrip.
Buying A Put:
Consider a scenario where stock prices are falling. A person may not own a particular stock or if he does, he may not want to trade in the stock for fear of not being able to buy it back. He may also not want to go short in the high risk futures market. The safest way of benefiting from the fall in stock prices would be to buy a put. The price of the put will keep rising as the market falls and he can sell the put option at a higher price. Or the buyer can exercise the put option i.e. he can obligate the option seller to buy the stock at the strike price whatever be the market price.
Selling A Call
Selling options is fraught with risk as the scope for loss is unlimited. A person who is sure that the markets will fall can sell a call option of high strike price. He will pocket the entire sales proceeds of the option or he can buy back the call option at a lower price as long as the market falls.
One can profit from falling stocks as long as one proceeds with caution and trades with stop losses in place.