Trading Both Sides of the Market By Larry Benedict, editor, Trading With Larry Benedict The bull market is entering its third year. And folks have become highly familiar with the “buy” side of the market. Of course, there have been dips along the way – such as April’s tariff-induced selling. But dip buyers who held on for the ride have typically been rewarded. As I’ve been discussing in my podcast, Trading With Larry Live (8:30 a.m. ET, Monday through Thursday), these folks can’t seem to find any excuse to sell. It’s like they think markets are just going to go up forever… But you need to learn to take your profits. You also need to learn how to “short” the market. That’s where you’re aiming to profit from a stock’s fall. Because eventually, this bull market will end. And until you get comfortable trading both sides of the market, you’re limiting your trading opportunities. So today, I want to show how you can take advantage of a stock’s fall… | Recommended Links
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| Short-Selling Stock One way to capture an anticipated fall in a stock is by short-selling shares. It’s a strategy that hedge funds use all the time. It involves borrowing shares and then selling them. You aim to profit by buying them back (and returning the shares to the original holder) at a lower price. For example, say you borrow shares and sell them for $50 per share. The share price falls to $45, so you buy the shares back and keep the $5 difference when you return the shares to the lender. This may be a popular strategy, but it comes with several challenges… For a start, a stock can only fall to zero. So, the profit on any short trade is capped. At the same time, a stock can technically rise to infinity, meaning that your potential loss is unlimited. So the risk/reward relationship is asymmetrical… and not in your favor. And there’s another problem that relates to your exposure… If you buy shares, your exposure decreases if the stock price falls. But the opposite applies with short-selling. The more a short position goes against you, the bigger your exposure becomes. Consider someone who shorts 1,000 shares at $50. They’re short $50,000 worth of stock overall. If the share price rallies to $60, their exposure would increase to $60,000. In essence, they’re now short an additional $10,000 worth of stock. You can see how a runaway rally could cause devastating losses. That’s why I prefer a different strategy…
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| It’s About Managing Risk Rather than shorting shares, I buy put options instead. A put option increases in value when the value of the underlying stock falls. Buying a put option enables me to profit from a falling stock without having to short shares. It’s cleaner and much easier to implement – and also more readily available to retail traders. Another major benefit of buying options is that I always know my maximum risk – the premium I paid for the option. So, for example, I typically look to pay around $3 for an option. Option contracts are for 100 shares, so that’s $300 a contract. Even if the put option trade goes terribly wrong and the stock price soars, the most I can lose is $300 per contract. That maximum loss doesn’t change. Compare that to potentially unlimited losses from short-selling shares. And because you’re only risking a fraction of the amount of shorting shares, you can afford to re-enter the trade later if the initial position doesn’t go your way (if you’re still confident about the thesis behind the trade). Like anything, there are drawbacks… The primary risk is that options expire. And the value of your option erodes the closer you get to expiry. If you don’t get the move you’re anticipating, your option can expire worthless. However, the benefits of options usually outweigh these potential downsides. Markets are in bull market mode due to thawing relations between China and the U.S. and the prospect of another rate cut. At the same time, catalysts are stacking up that could derail the market and lead to a fall. But by using a put option strategy, you can take advantage of any future sell-offs. Happy Trading, Larry Benedict
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