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How to Make Money Betting Against StocksBy
Thursday, January 21, 2016
How do you profit when stocks are falling?
The short answer is, "Not very easily."
Betting against stocks is a tough business. That's a big reason why the sophisticated computers behind my True Wealth Systems service haven't signaled a "short" trade in the last five years.
But earlier this month, they did for the first time.
This doesn't mean the market will crash. In fact, this is a specific bet. And today, I'll show you why this type of bet can work... And exactly what to look for if you want to profit on the downside.
Let me explain...
In November, I explained what to look for when betting against the entire market. In short, you only want to bet against stocks when they're expensive and in a downtrend. But betting against individual stocks or sectors is different...
What do we look for when we bet against a sector? It's simple – the opposite setup of what we want when we buy a sector...
When we buy, we want to see a sector that is 1) hated, but 2) in an uptrend.
This is my longstanding investment prism. By following it, we ensure we buy 1) good value, when 2) no one is interested, and 3) after the trend has moved in our favor.
Following these rules can lead to outsized gains and actually lower our risk.
And in order to bet against a sector, we want to see the exact opposite... We want to see a sector that is 1) loved by investors, even though it's 2) in a downtrend.
This doesn't happen often. Investors usually end up scared, quickly, after a downtrend begins.
Think about how it feels in the markets today.
Stocks have had a rough start to 2016. They're now nearing multiyear lows. But you don't hear anyone preaching about "buying the dip."
Everyone is scared right now. No one sees this fall as an opportunity. No one is saying "buy."
That's normal. I'd really be scared if investors were extremely bullish in spite of a dramatic fall in prices. That would be the recipe for larger losses.
We've seen this in recent years in places like Russia...
I explained what was going on in Russia to DailyWealth readers in November 2014. In short, Russia's stock market was crashing. But foreign investors were ecstatic to buy.
Shares outstanding of the Market Vectors Russia Fund (RSX) had soared... which showed investors were pouring money into Russian stocks.
This was a case where a market was crashing, but it was still loved by investors. So what has happened since?
Shares of RSX are down 36% since that essay was published. That would have been a great time to bet against Russian stocks.
This is just an example, of course. But the idea is important. In order to make money on the downside, we want to see a sector that is 1) loved by investors, even though it's 2) in a downtrend.
If you're looking to short a stock or sector, find one that investors love despite a downtrend. That's the recipe for further losses.
Good investing,
Steve
Further Reading:
"Short selling is an important strategy for any portfolio," Jeff Clark writes. Learn how to start making money on short trades here and here.
Market NotesTHIS RATIO JUST HIT AN ALL-TIME HIGH Today, an update on the most important ratio you're not following... the "gold-to-oil" ratio.
Most folks don't know about it, but there's an interesting class of trades that can be called "ratio trades." These aren't the conventional stock trades. They involve trading one asset against another asset.
Since they are both commodities that have intrinsic value, gold and oil can be affected by the same buying and selling pressure in the market. But their values can get "out of whack." When this happens, traders can profitably sell gold and buy oil... or vice versa. The profit on these trades depends on how the two assets move against each other.
As you can see below, buying gold right now and shorting oil is a smart bet. The ratio just struck a record high of 37 (meaning you can buy 37 barrels of oil for just one ounce of gold today). The gold-to-oil ratio continues to work in gold's favor...
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