How to make money in falling market?

In bearish runs like this, it is important to learn and know how to make money from falling markets to ensure that income keeps flowing in

· 4 min read
How to make money in falling market?

Today, on 25th March 2021, the Nifty fell 1.54% to 14,300 levels from its all-time high of 15,300, which is a massive 1,000 point fall in just 12 days. In massive movements like this, a lot of wealth is lost, a lot of unrealized profits goes unrealized and plans for the future could be disrupted too.

In bearish runs like this, it is important to learn and know how to make money from falling markets to ensure that income keeps flowing in or at least to be able to reduce any potential losses on your overall P&L.

This is done using two very useful instruments - shorting and put options.

What is shorting?

Short-selling is done when a trader wants to sell a security on the open market at a high price and buy it back at a lower price. This is the opposite of most investments where you buy first at a low price and sell at a higher price. What happens in this process is, say, you place a short order of 50 shares on ITC (NSE: ITC) expecting its price to fall from ₹210 to ₹200. Now, your broker will sell the shares of ITC it keeps as a reserve on the market on your behalf. When the share price eventually falls to ₹200, you buy the share back from the market and return the share to your broker.

Image credits: WallStreetMojo

This entire process is done behind the screen by brokers nowadays so you don't have to worry about it, you will just have to push the sell and buy buttons on your brokerage platform.

However, the major issue with short-selling is that the risk of loss on a short sale is theoretically infinity as the price of a security can go to infinity. To avoid this issue, Indian brokerage platforms allow short sales of securities only on an intraday basis. This means you cannot hold a short position in the cash market for more than one entire trading session and your broker will square off your position by market close.

What are put options?

Options contracts are a financial derivative that offers the buyer the opportunity to buy (AKA call options) or sell(AKA put options) the underlying asset without having the obligation to. If you have a bearish view on a stock or the market for multiple days then buying a put option contract is much better than short-selling the concerned securities.

(For simplification, we're only considering monthly options)

Another exciting feature about buying put options compared to short selling the security is the massive price fluctuation. If your view is right, the market will reward you with much more extraordinary returns than short-selling the respective security.

The Nifty index here fell by 2.10% over 1 day and 40 minutes

Nifty put option at strike price 14600 went up by a massive 403% over the same time frame!

However, note that these returns do not happen all the time and it is highly advisable to not take trades with extremely high capital all the time expecting these results. Only put in money that you can afford to lose.

Similar results can be achieved by selling call options as well.

Hedging - the ultimate portfolio protection

Most people who are in the stock market don't trade on an intraday basis as it clashes with their jobs. So they tend to have a portfolio of a few stocks, mutual funds, or ETFs looking at a longer horizon. However, market downturns in the short term can cause major damages to portfolios and financial planning of families who grow their wealth in the stock market. To cushion the fall, and potentially even make money, a practice called hedging is very useful.

Although famously practiced by hedge funds, hedging is done to minimize losses in equity by having protection in derivatives. For example - if you were invested in ITC and you sensed a major fall around the corner, you would buy a put option or sell a call option to ensure that you make money in derivatives in this short term fall while holding on to your long term position in the cash market.

Conclusion

One can always make money from falling markets by either short-selling securities falling in value or buying put options/ selling call options on that security. Short-selling is easier and is less prone to massive fluctuations but you can hold a short position only till the end of the day, unlike a put/call option where you can hold the position until the last Thursday of the month.

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