How To Profit From The Inevitable Sell-Off

By StreetAuthority | October 21, 2013 AAA

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. 

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.

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.

 


SH) and Short MSCI Emerging Markets (NYSE: EUM). Leveraged inverse ETFs include Direxion's Daily Large Cap Bear 3X (NYSE: BGZ)Daily Real Estate Bear 3X (NYSE: DRV) and the aptly tickered Daily Health Care Bear 3X (NYSE: SICK), among many others.

Non-leveraged inverse ETFs can be bought and held just like any stock. They are ideal for catching long-term down trends in whatever the underlying instruments are. 

Risks to Consider: Shorting stocks goes against the long-term upward trend of the stock market. However, it can be a highly effective tool for profiting from negative events and other sell-offs. Theoretically, your risk is unlimited should a shorted stock keep going against your position without you taking the loss. However, in reality, stocks don't move upward forever. Regardless, shorting stocks is risky, requiring timing and experience. Buying a put or using non-leveraged inverse ETFs is a much simpler way to profit from an expected sell-off. If you are able to time the selling, a triple-leveraged inverse ETF makes sense for a short-term holding period. Be prepared for heavy volatility.

Action to Take --> Practice shorting stocks in your demo account. Most brokers have a demo platform that allows you to practice various investments and trades. Try a leveraged inverse ETF and buying a put in your demo account as practice before using real money. Note how the investments move relative to the underlying instrument, as well as how much margin is required to short directly. If you take the time to practice shorting, your chances of not making rookie mistakes with real money increases exponentially.

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