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Two Simple Ways to Profit From Falling Stocks

By Brian Hunt and Ben Morris, editors, DailyWealth Trader
Tuesday, August 18, 2015

We're in one of the longest bull markets in U.S. history... And lots of folks are worried it's coming to an end.
 
We're seeing signs of weakness, too...
 
The uptrend has clearly slowed... And lots of stocks are hitting new lows, even as major indexes (like the S&P 500) are trading near all-time highs.
 
You've probably felt it in your personal portfolio.
 
We're not predicting an all-out bear market just yet. But we like to be prepared for the worst-case scenario.
 
So today, we'll show you two simple ways to profit from falling stock prices. By holding a few positions that profit in a down market, you can reduce your overall stock-market risk.
 
Let's start with one of the most common bear market strategies: short selling.
 
In conventional stock buying, you try to buy low and sell high. But when you sell a stock short, you flip that around. You try to sell high first and then buy low.
 
Here's how it works... When you place the order, your broker loans you shares and sells them in the open market. You get the cash from the sale.
 
Then at some point in the future, you need to repay the loan... You need to buy those shares and return them to your broker. (This is called "covering" your short.) If you pay more than you earned from the original sale, you take a loss on the trade. If you can buy the shares back for less, you keep the difference and profit.
 
(Learn more about selling stocks short here.)
 
When you look for stocks to sell short, you can use the opposite thought process utilized when buying a stock. Generally, you want to buy stocks that have big-picture trends working in their favor. When you sell stocks short, you look for the opposite. Our publisher Porter Stansberry, for example, likes to short stocks with obsolete business models.
 
Or consider our colleague Steve Sjuggerud's incredibly successful strategy of buying assets that are "cheap, hated, and in an uptrend." Searching for the opposite of that – expensive, loved, and in a downtrend – is a good way to find short-selling winners.
 
Take former market darling 3D Systems (DDD), for example.
 
From 2010 to 2014, 3-D printing became one of the world's biggest tech stories. 3-D printing is the printing of solid objects... rather than conventional "on-paper" printing. The industry uses computers and special materials to "print" things like tools, guns, and toys. 3D Systems is one of the biggest players in the industry.
 
As the promise of 3-D printing hit newspapers and YouTube, folks got excited. 3D Systems climbed from $10 per share to $97 per share, a gain of 870%.
 
After this run, the stock became outrageously expensive at more than 20 times sales. (A price-to-sales ratio of 10 is very expensive.) In a note to DailyWealth readers, we said it was a dangerous stock and vulnerable to a big drop.
 
By last October, 3D Systems was down more than 50% from its peak and was clearly in a downtrend. Yet the stock was still expensive at nearly eight times sales.
 
 
It would have been a great short sale. You could have borrowed and sold shares at $40, then bought them back nine months later for less than $20. That's a $20 profit per share... more than 50% of your short-sale price.
 
Of course, it's easy to look back and pick an example. It's much harder in practice... especially during a bull market. In DailyWealth Trader, we attempted to sell shares of mall operator Simon Property Group (SPG) and electric-car maker Tesla (TSLA) short. We took losses on both trades...
 
That's OK. Selling short serves as a hedge to your portfolio. In a bull market, expensive stocks can get more expensive. Even if you take losses on your shorts, your "long" positions will likely be profitable. And, if the market takes a dive, your overvalued short positions are likely to fall more than other stocks. Your profits on your short trades will offset some of your losses.
 
If selling a stock short sounds too complicated, there's a simpler way to profit from falling stock prices.
 
You can buy "inverse funds."
 
Inverse funds can be bought and sold just like stocks... or like other exchange-traded funds (ETFs). But they increase in price when the underlying asset (like a stock index) falls.
 
It's a way to short stocks without borrowing shares from your broker. For example, the ProShares Short S&P500 Fund (SH) is an inverse fund that is designed to increase 1% for every 1% drop in the S&P 500 Index. The ProShares UltraShort Financials Fund (SKF) is designed to increase 2% for every 1% drop in the Dow Jones U.S. Financials Index.
 
When you want to buy an inverse fund, look for market sectors that are expensive relative to their history. If share prices start falling, it could be a good time to buy an inverse fund.
 
Keep in mind, inverse funds can work great for short-term trades... But many of them bleed value over time. (Their gains tend not to match the losses of the underlying asset.) So you should do a little research before buying an inverse fund.
 
To summarize, short selling and buying inverse funds are two simple ways you can directly profit from falling stock prices. They're tough to get right in a bull market... But they're a great way to hedge the bullish portion of your stock portfolio. If stocks start to move lower, they're two of the first strategies you can use to profit.
 
Regards,
 
Brian Hunt and Ben Morris




Further Reading:

Earlier this year, Jeff Clark shared his favorite patterns for identifying short-selling opportunities... These are the chart setups he looks for to profit as stocks move to the downside. Find out what they are here and here.
 
Brian and Ben recently shared a simple and powerful way to save your portfolio from the next market crash. "In the case of an all-out financial storm (like many are predicting right now), this will prevent catastrophe," they write. "It has worked in the past... and it will very likely work again." Get all the details here.

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