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3 Ways To Profit From The Inevitable Sell-Off

Wednesday, March 19, 2014 - 7:00am

As you may have noticed, the stock market has sent investors on quite a ride already this year.

The market lost nearly 7% in just a couple of weeks between mid-January and early February, sparking fears that a sharp correction was imminent. Those fears have turned out to be a bit premature, as the market has since nearly recouped those losses.

Hype and perception often have a more powerful effect than reality on short-term stock price movement. It may seem counterintuitive, but that's the typical pattern.

Of course, 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.

1. Shorting Shares

The most popular way to profit from a down market or stock is through shorting. This means you place a trade in anticipation of the price falling rather than appreciating. I know it sounds complicated, but it's actually quite easy.

The way it works is, your broker lends you the shares at a certain price. The goal is to sell the shares back to your broker at a lower price, and you get to keep the difference between the lent (short) price and the price that you sell the shares back to your broker.

Selling the shares back is called covering. Shorting can be done with individual stocks or exchange-traded funds (ETFs). An ETF such as the SPDR S&P 500 (NYSE: 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.

2. Put Options

While there are all kinds of different option strategies for a wide variety of stock market conditions, buying a put is the simplest way to profit from a decline. A put option is a bet that the stock or ETF will fall in price within a certain timeframe. It climbs in price as the share price drops.

Buying a put limits your downside risk to the price you paid for the option. However, puts are very time-sensitive. This means that not only does the underlying share price need to drop, but it needs to drop within the lifespan of the put. Most puts expire on a monthly basis, and they all decrease in value as the time to expiration draws closer.

Puts are highly effective tools for betting on a particular known event's effect on price. If you anticipate the earnings report will be bad for a particular stock, buying puts to benefit from the resulting price drop makes sense.

3. Inverse ETFs

ETFs have opened new markets to investors.

Today, investors can access markets, indexes and complex trading ideas with the same ease as purchasing a share of stock through ETFs. A certain breed of ETFs known as inverse ETFs earns profits when the underlying instruments drop in value. This is accomplished by a complex mixture of future contracts and other derivatives to obtain the inverse movement in the ETF. Fortunately, as investors, we don't need to fully understand the mechanics of how inverse ETFs actually work. Our job is to understand how to use them for maximum profit.

Inverse ETFs are available on a variety on underlying stock indexes. There are even inverse ETFs that leverage the underlying index as much as three times. In simple terms, 3X leveraged inverse ETFs move 3 points for every 1 point the underlying index moves. This leverage makes them extremely volatile, and they're designed to follow the daily motion of the index not the long-term motion. This makes leveraged inverse ETFs only suitable for short-term, sophisticated investors who fully understand the risks and how they work.

Examples of inverse ETFs include ProShares' Short Dow 30 (NYSE: DOG), Short S&P 500 (NYSE: 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 is risky because it goes against the long-term upward trend of the stock market. It requires expert 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 virtual account. Most brokers have a 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 increase exponentially.

This article was originally published Oct. 21, 2013.

P.S. Selling puts isn't just a powerful way to profit from a sell-off -- it's also a fantastic way to multiply the income of the rock-solid stocks you already own. My colleague Michael Vodicka has prepared a free report, "3 Easy Steps to Multiply the Income of the S&P 500's Largest Dividend Payers." Click here to get your copy now.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.