Stocks are near their all-time highs, and despite gains since the election it’s only natural to wonder if uncertainty in Washington or some overseas event could hammer the markets.
“It would certainly be difficult to argue that the current equity markets are undervalued,” says Robert R. Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania, though he warns of many risks of betting on a downturn.
If you believe a correction is coming, how do you bet on it? The pros do this all the time with fancy strategies that mix going “long,” or owning stocks they hope will rise, with going “short,” or betting stocks will fall. But ordinary investors can do this too.
One of the most common ways is to short an individual stock, an index representing a portion of the market, or an exchange-traded fund. In a short sale, the speculator borrows shares from a broker, sells them and hopes to profit by purchasing replacements at a lower price. It’s still buying low and selling high, but in reverse order.
[See: 10 Long-Term Investing Strategies That Work.]
“At record highs in the stock market, valuations are expensive,” says Mark Painter, founder of Everguide Financial Group in Berkeley Heights, New Jersey, adding that “this is one of the best times I have seen to find individual companies to short.”
Another popular method is to buy put options contracts. Each contract gives its owner the right to sell 100 shares of stock, an exchange-traded fund or a broad index like the Standard & Poor’s 500, at a set price for a limited period of days to years. If the share price falls, the speculator buys at the low price and exercises the option to sell at the high price.
But although both techniques are available to small investors, experts say these are risky moves for anyone whose experience is limited to buy-and-hold mutual fund investing.
Among the issues with both: you are betting against the market’s long-term upward trend.
“Over time, the stock market goes up in value,” Johnson says. “Since 1926, according to data compiled by Ibbotson Associates, the stock market has advanced on average 10 percent annually. Thus, short sellers are attempting to buck a strong trend.”
An investor who goes long (owning stocks) has time on their side, knowing that in the past the markets have recovered from even the deep sell-offs of the Great Depression and Great Recession.
Betting against the market thus means hoping for a drop that’s likely to be temporary. Time works against you, and holding onto a short position as the market continues climbing can just deepen your losses.
“The process of shorting a stock can become very costly and therefore it is prudent to only hold shorts for a minimal amount of time,” says Daniel Lugasi, portfolio manager at VL Capital Management in Orlando, Florida.
Because of that, betting against the market requires constant vigilance. Is this dip all you’ll get? Or will it continue? Is an upward move proof you were wrong, or is the market just trying to fake you out? Professionals think about this all day, every day, and most amateurs just don’t have the time.
Another issue is cost. With a put, the investor must pay a premium to buy the contract. Premium prices are driven by market forces and can be quite large for contracts likely to make a profit. Once the option deadline arrives, the unprofitable out-of-the-money contract expires worthless. An investor who bought one put after another in hopes of a market decline that never came could be out a lot of money.
Until the short seller replaces the borrowed shares she’d sold, she’s charged interest on the loan and must pay the dividends due to the buyer of the shares. The costs mount over time and offset gains or deepen losses.
With a short sale, costs of commissions and even interest might be relatively modest compared to the costs of buying a put. But the big risk is if the market goes up instead of down, and the higher it goes the more the investor stands to lose, since market price will eventually have to be paid to replace the borrowed shares.
[See: 7 Stocks That Could Save Your Portfolio.]
If the investor sold short at $100 a share, the loss would be $400 a share if the price soared to $500. But the investor could never make more than $100 — and that only if the price fell to zero and the borrowed shares could be replaced for nothing.
The risk of unlimited losses makes shorting too dangerous for amateurs, Johnson says. “A much better strategy is to buy put options on individual stocks that the investor feels are overvalued. This allows the investor to take advantage of a correction, yet limits losses to the premium paid,” he says.
Risk versus reward for shorting is “extremely unbalanced,” Lugasi says.
“The maximum gain on a short sale is 100 percent if the stock goes to zero. The maximum loss for a short seller is unlimited because there is no limit to how much a stock can increase in value,” he says. “Purchasing put options is a less risky alternative to obtaining short exposure on a stock with the only cost being the contract price.”
Painter sees it the other way, arguing beginners have a hard time with all the options’ complexities. “I would never recommend using put options in place of a short position,” he says. “Options have a lot more variables in their pricing than a stock and you have to not only be right about direction, but also with timing, because options expire while a short position has no timetable.”
While Painter thinks today’s conditions favor shorting, Johnson does not. “I am not convinced that markets are necessarily overvalued or poised for a significant correction as many suggest,” Johnson says.
He notes that price-earnings ratios for U.S. stocks are on the high side of historical averages, but not especially high for periods of exceptionally low bond yields. Low interest rates tend to boost stocks because competing investments like bonds are less attractive and because low borrowing costs are good for corporate profits.
With either strategy, a beginner would face unfamiliar risks, and Johnson says most small investors should avoid betting against the market, period. “For a long-term investor, trying to time a market correction is a loser’s game,” he says.
[See: 11 Great Investing Tips for Women.]
“To correctly time the market you must make a series of good decisions: When to get in, when to get out, and when to get back in again,” he says. “It is a much better strategy to simply focus on your long-term investment goals and maintain your target asset allocation through market ups and downs.”
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How to Bet Against Stocks originally appeared on usnews.com
