Investing: Make Your Dollars Work for You

How to make money when stock prices are falling

Are you under the impression that stocks have to go up to make money with them? You can always make money with stocks, you just have to decide if you think they’re going to go up or down and be right!

There are 3 common ways that money can be made when a stock price falls. So you don’t have to buy low and sell high.

Here are 3 simple ways to act on your belief that stock prices are going to drop:

Short stocks

Few people actually understand how you can do this. Instead of ‘going long’, you’re ‘going short’. If the stock goes down, you make money. If you find a stock that you believe is going to drop in value, shorting allows you to make money on this decrease in value, if you’re right.

Set up a margin account with your online broker and get approved for short selling. You are actually going to borrow shares that you don’t own from your broker or another investor (you don’t know the source of the shares). These shares are then sold, and the money is kept in your account. When the stock price falls, you would then buy back the shares. The shares would be transferred back to the original owner.

Since you bought the shares for less money that you sold them for, you get to keep the difference. The original owner only gets their stock back, not the money. But what if the stock price goes up? Then you would get a margin call from the broker and have to buy back the stock at a higher price. You would then lose money. You can’t short stocks in IRAs. This type of activity is illegal in Individual Retirement Accounts. You also must repay any dividends you might receive while you are borrowing the stock.

In theory, shorting stocks can be riskier than going long on stocks. A stock price can only fall to zero, but it doesn’t have a true ceiling. You can also wait out a stock forever if you own it and you’re going long. When you go short and the price heads in the wrong direction, you’re going to get that margin call sooner or later.

Buy puts

Buying puts is a form of options trading that allows you to lock in a price (the strike price) at which you can sell a stock in the future. There is a deadline, however. You have the option of selling the stock in question, at that price, before the deadline. So, if you bought puts that allow you to sell a stock at $100/share, and the price falls below that amount, you would make money. However, if the price is higher than $100, the option would expire and you would lose your option money. Most options expire without being exercised.

In essence, to exercise the option, you have to buy the stock at the current price and then can sell at the strike price. So if the stock is currently $80/ share, you could buy it at $80 and sell it at $100 (in our example). Obviously, if the current price were $110, you wouldn’t want to buy it at $110 and sell it at $100. You would just let the option expire.

Buying puts is relatively risk free because you can’t lose more than the cost of the options. It does, however, allow the opportunity to make a ton of money if the stock really falls. Options are relatively inexpensive and correspond to 100 shares each. So a little bit of money controls a lot of stock. The caveat is that you have to have the money to actually buy the stock when the time comes. You can’t sell what you don’t own. Even if you don’t have the money, it’s not too difficult to find a source when there is a guaranteed return.

Write covered calls

Writing covered calls allows you to make money if the stock stays at the same price or drops. You actually make money when the price goes up, too. However, you won’t make as much as you can when the price drops. Let’s look closer.

When you write covered calls, you’re giving someone else the right to buy your stock at a set price before some date in the future. You can only write covered calls for stocks you own and only in increments of 100 shares. 100 shares are referred to as one ‘contract’. The price of a contract is frequently only a couple of dollars. It varies with the strike price and the expiration date. Imagine controlling 100 shares of stock with a dollar! You can find all the pricing information online on any brokerage or stock website. Google and Yahoo both have the information on their financial sites. The listings are pretty self-explanatory.

If the stock loses value or stays the same, you get to keep the option money. At the very least, writing the covered call will offset some of your loss. It’s largely a loss mitigation strategy. If the stock increases in value enough to cover the strike price, you can be forced to sell your stock at that price. But you get to keep the option money and you got to sell your stock at a profit. It’s just that you would have had more profit if you could have kept your stock plus the price increase.

Writing covered calls is a minimal risk way to make more money with your stocks. The only risk is that you wouldn’t get all the gains if the stock goes up markedly. You can also write uncovered or ‘naked’ calls. In this case, you don’t own the stock in question. What that means is, if the option is exercised, you have to go out and buy all the shares at the current price and sell them at the strike price. Very risky! You can lose a ton of money in a hurry.

Take Away

There you have 3 relatively simple ways to make money with stocks when stock prices are falling. There are others, but these 3 are also lower in risk. Don’t let anyone tell you that you can only make money when stocks are going up in value. As long as you can accurately predict what direction a stock is heading, there is always a way to make money.

While these methods are simple, you will still need to do a little research and really familiarize yourself with them. Never throw caution to the wind with your money. There is a big difference between the different types of options. You can avoid mistakes with careful due diligence and research. It’s tempting to write naked calls, since you can make money without having any assets tied up. But if the option is exercised, you’re potentially on the hook for a lot of money.

Be safe and make some money, even if the market is going down!