How to Make Money in an Overvalued Market – Investing Daily

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Short sellers sometimes get a bad reputation.

Most investors are long. They purchase a stock and make money when the stock goes up.

But short sellers have the opposite interest. They want stock prices to drop, the lower the better. When they sell a stock short, they put downward pressure on the stock price. If you own the same stock, that hurts you.

As the market crashed in February and March and put a big dent in your investment portfolio, somewhere short sellers were happy. Your pain was their gain.

It’s understandable why investors on the long side of the trade might dislike short sellers.

How Short Sellers Help the Market

However, short sellers can actually help the market in some ways.

First, short sellers improve the market’s liquidity. A trade happens when you have one party willing to buy and one party willing to sell at the same price. The buyer thinks the stock will go up, and the seller thinks the stock will go down.

Without a buyer and a seller who agree on a transaction price, no trade can occur. If everybody thinks a stock will rise and wants to buy, and you don’t have many sellers, then not many trades will happen and the stock price will get inflated.

Short sellers short a stock when they think it’s overvalued. They fill the sell side of a trade. Their involvement brings more trading volume—i.e., they increase liquidity.

Besides helping to provide liquidity, short sellers also bring balance to the market. As mentioned a moment ago, having too many buyers inflates a stock price. When a stock price starts to get too high, it attracts short sellers, who help to balance demand and supply.

Put another way, short sellers help to make the market more efficient. Shorting is a legitimate way to make money. There is nothing wrong with betting against a stock. You are still trying to buy low and sell high, except when you short you are selling before you buy.

The Risk of Shorting

Note that short selling requires the use of a margin account. You are able to borrow funds from the broker to buy. In the case of shorting, you borrow shares of the stock to sell. You will need to maintain minimum equity in your account to ensure that you can buy back the stock you shorted.

If the stock(s) you shorted rally enough to trigger a margin call, your broker will forcibly buy to cover your short positions, locking in your losses. In the history of the stock market, many short sellers have been burned by unexpectedly strong rallies. When short traders are forced to cover their positions (buy) en masse, it superficially pushes up the stock price, which triggers more short covering. Things can get ugly quickly for short sellers caught in the short squeeze.

Since there is no upper limit to how high a stock can go, the risk of loss from short selling is theoretically limitless. In practice, you can put a buy stop order in place to buy back the stock if it reaches a certain price. Even if you don’t put that safeguard in place, the broker likely will have a stop order to automatically buy back at some price point.

Still, the point is that if things go against you when you are shorting, you could lose a lot of money, sometimes more than 100%.

A Less Risky Alternative

As an alternative to consider, buying a put option also allows you to bet against the market. A put option gives the buyer the right, but not the obligation, to sell to the counterparty, at or before option expiration, shares of the underlying stock, at the strike price. Each contract represents 100 shares of the underlying stock.

Let’s say you have three contracts of the $20 put on stock XYZ. If XYZ is at $18 at expiration, you can sell 300 shares of XYZ to the counterparty at $20, $2 above market price. (In reality, most option holders will close the position before expiration.) Your gross profit will be $600 ($2 x 300). Your net profit will be the gross profit minus the premium you paid for the option and trade commission.

Assuming you hold the option to expiration, if the market price of the stock is above the strike price, then the option expires worthless, and you lose the entire premium paid. However, no matter how high the stock price ends up at expiration date, you won’t lose more than what you originally paid for the put.

You can buy puts against individual stocks or ETFs, including ETFs that track market indexes. Options have different strike prices and expiration dates to choose from so you can really narrow down your strategy to do exactly what you want to do.

Editor’s Note: Scott Chan just provided invaluable investing advice. But we’ve only scratched the surface of our team’s expertise.

Our mutual colleague Dr. Stephen Leeb understands current market risks and opportunities as well as anyone, which is why he’s been guiding his subscribers to win after win in any investing environment.

Dr. Leeb, chief investment strategist of The Complete Investor, has coined a term for the stock market’s recent ups and downs. He calls it “Reset 2020,” and he believes it signals a paradigm shift in how equities will be valued in the years to come. To learn more about this shift and how to profit from it, click here for our special report.

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