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Don't Overlook This Half of the Market

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Friday, 15 April 2016 07:14 AM Current | Bio | Archive

Stocks go up, and they go down. The funny thing is, most investing is focused on stocks that go up. That makes sense in a lot of ways—markets do tend to rise over time. But nothing happens in a straight line.

If you’re only buying for the long haul, you’re missing out on profits from half the market’s swings.

Right now, following a powerful multi-week rally and with the start of what’s expected to be a dismal earnings season, it might be the time to profit from the downside. How? By shorting.

Simply put, shorting is when you sell shares first and buy later. You’re expecting that the share price will fall, so that when you buy to close the position, you make a profit.

But here’s the thing. Shorting is expensive. Stocks have to be borrowed short, and the costs of doing so can range from anywhere from 5-50 percent of the share price annually. And if the trade goes against you, which will happen at least as often as a long trade you make falls, you could face a margin call quickly.

Even if you’re right and you sell short a stock that goes to zero, the most you can make is 100 percent. Rather than be completely avoid this half of the market, though, consider a strategy with a lower risk and higher reward.

Specifically, you can buy put options. A put option bets on a stock’s downside. But since you’re buying an option, the most you can lose is the amount you put into the trade.

There’s no problem with a margin call there. And instead of a 100 percent cap on your potential profits, you can make far bigger percentage gains.

Right now, several stocks look set for a sizeable pullback. There’s electric car maker Tesla Motors (TSLA), which is a darling story stock. So far, the story is strictly a fairy tale. Mr. Market doesn’t care that the stock has no earnings. Or that they lose a little bit of money on every car that they sell, even as sales rise. At some point, earnings will matter again. Shares will fall hard.

Amazon (AMZN) is a popular name in the retail/tech space. The company has demonstrated that it can produce earnings when it needs to in recent quarters following years of plowing all their free cash flow into research and development. Yet shares trade at a lofty valuation on dreams of a brighter future, where drones deliver packages to your doorstep and every corporation uses their cloud service.

Finally, shares of Facebook (FB) look reasonably priced… if you think it’s fine to pay 85 times earnings. This is another tech-darling play that has far outperformed the broad market in the past year and is due for a sizeable pullback.

For each of these three story stocks, buying some long-dated put options (say an October or January strike price) well below today’s prices could lead to double-digit returns on a small market selloff. But on a bigger selloff, like another 10-percent correction, they could bring about triple-digit returns. 

Market sentiment is bright right now. It’s time to think about bringing along an umbrella for the inevitable rainy day.

Andrew Packer is a Senior Financial Editor with NewsMax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and is managing editor of Financial Intelligence Report.

© 2018 Newsmax Finance. All rights reserved.

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Stocks go up, and they go down. The funny thing is, most investing is focused on stocks that go up. That makes sense in a lot of ways-markets do tend to rise over time. But nothing happens in a straight line.
stocks, market, invest, options
Friday, 15 April 2016 07:14 AM
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