How To Profit From The Inevitable Sell-Off

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The stock market has been on a wild roller-coaster ride recently.

Political posturing, the government shutdown, debt default fears and an earnings smorgasbord have all hit stocks at the same time — but despite the bumpy ride, the action has been textbook for experienced investors.

We witnessed the fear of a government default knock shares lower for several weeks, and then rumors of a solution sent markets surging higher. However, when the final-hour solution was finally announced, stocks slumped. This sell-off may have left many investors dumbfounded on why stocks sold off to great news — but it happens often in the financial markets

This is a classic example of the “buy the rumor, sell the news” effect. Hype and perception have a more powerful effect than reality on short-term stock price movement. In other words, the excitement associated with the possibility of a bullish event is the true bullish price driver. When the actual event occurs, the bullish excitement is gone, and the big-money investors take profits, sending the market lower. It may seem counterintuitive that perception matters more than reality for short-term stock price movements, but that’s the typical pattern.

8 Sector ETFs for 2013

Many other factors can cause stock prices to drop. Macroeconomic fears affect the broad market in a negative way, and individual stocks can get knocked down for dozens of reasons: missed earnings estimates, poor quarterly results, negative rumors, management shenanigans, even simple profit-taking.

The good news is that savvy investors can profit from this inevitable negative stock market action in three primary ways.

1. Shorting Shares

The most popular way to profit from a down market or stock is through shorting. This means you place a trade in anticipation of the price falling rather than appreciating. I know it sounds complicated, but it’s actually quite easy.

The way it works is, your broker loans you the shares at a certain price. The goal is to sell the shares back to your broker at a lower price, and you get to keep the difference between the loaned (short) price and the price that you sell the shares back to your broker.

Selling the shares back is called covering. Shorting can be done with individual stocks or exchange-traded funds (ETFs). An ETF such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) can be shorted to participate in broad market sell-offs. You need to have a margin account and be approved for short selling at your broker in order to sell short.

2. Put Options

While there are all kinds of different option strategies for a wide variety of stock market conditions, buying a put is the simplest way to profit from a decline. A put option is a bet that the stock or ETF will fall in price within a certain timeframe. It climbs in price as the share price drops.

Buying a put limits your downside risk to the price you paid for the option. However, puts are very time-sensitive. This means that not only does the underlying share price need to drop, but it needs to drop within the lifespan of the put. Most puts expire on a monthly basis, and they all decrease in value as the time to expiration draws closer.

Puts are highly effective tools for betting on a particular known event’s effect on price. If you anticipate the earnings report will be bad for a particular stock, buying puts to benefit from the resulting price drop makes sense.

3. Inverse ETFs

ETFs have opened new markets to investors.

Today, investors can access markets, indexes and complex trading ideas with the same ease as purchasing a share of stock through ETFs. A certain breed of ETFs known as inverse ETFs earns profits when the underlying instruments drop in value. This is accomplished by a complex mixture of future contracts and other derivatives to obtain the inverse movement in the ETF. Fortunately, as investors, we don’t need to fully understand the mechanics of how inverse ETFs actually work. Our job is to understand how to use them for maximum profit.

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