Making Money When the Stock Market Drops

Misery may love company, but rather than joining miserable times, wouldn’t you prefer to profit instead?

That’s the idea behind short-selling a stock. The trader borrow shares a broker, then sells them. The trader hopes the stock will fall in price, enabling him to buy back the shares at a lower cost. The trader returns the stock to the broker, pocketing the difference of money received in the sale and paid out to buy back the shares.

Fund investors and traders can perform the same operation indirectly by investing their money in mutual funds that short stocks instead of buying them.

For instance, let’s say you believe a bear market has commenced. You could buy shares in any number of inverse-index funds in hope of profiting from the decline. That’s right. If the market falls, you could wind up making money.

These funds track their underlying indexes in reverse. When the index rises, the fund’s Net Asset Value falls. When the index falls, the NAV rises. The way they work is fairly straightforward. They simply short a representative sampling of the stocks in their target stock indexes.

Of course, an inverse-index will lose money during bull markets or rallies. So people who use short-selling funds do so as part of a larger strategy designed to take advantage market shifts between bull and bear cycles, or smaller rally and correction phases. This requires two or three funds.

For instance, you might move into a simple S&P 500 index fund when you’re bullish on the market. Then when you form an opinion that stock are entering a bear market, you could shift your money out of the S&P 500 index fund and into a fund that short-sells S&P 500 stocks. In times when you are less sure of the market’s direction, you could put all or part of your money into a money market fund.

Two fund families that offer inverse-index funds are Rydex and ProFunds.

In the Rydex family, the ^RYAIX^ aims to provide investment results that inversely correlate to the price movement of the NASDAQ 100 Index
($NDX). The fund shorts Nasdaq 100 stocks as well as uses futures and options to achieve its goal. Investors shift to the ^RYOCX^ when they hope “go long” Nasdaq 100, in other words, when they are betting that the Nasdaq 100 will rally. The ^RYURX^ seeks to inversely correlate to S&P 500. The corresponding long fund is the ^RYVNX^. Investors should be aware that the Rydex Nova fund is an enhanced fund which seeks to produce 1.5 times the percentage movements of the S&P 500.

ProFunds offer enhance short funds as well as straight short funds and enhanced bull funds. For instance, the ^BRPIX^ seeks returns that are opposite of the performance of the S&P 500. The ^ULPIX^ seeks returns that are twice the performance of the S&P. The UltraShort OTC ProFund seeks to double the inverse of the ^USPIX^.

When shorting stocks or buying short funds, it is critical to keep in mind the stock market’s positive long-term bias. Bull markets recover all the ground lost in the prior bears, then forge higher. And bull markets last longer on average than do bear markets. Just look at long term chart of the Dow Jones industrial average or the S&P 500. You’ll see that while each index incurred its down phases, the long-term trend has been toward higher share prices.

This makes sense. A share of stock represents an ownership stake in a U.S. company. A broad index represents overall U.S. industry. Technological advances and competition push corporate America to ever higher levels of productivity and efficiency. While some companies fail, corporate America in general becomes more profitable over the long run. So equities appreciate.

According to Ned Davis Research, the average length of all bull markets since 1900 was 736 days. The average gain on the Dow was 87%. The average bear market lasted 406 days and marked down the blue-chip index by 31%.

So you should never apply a buy-and-hold strategy to a fund that shorts the stock market. You would be betting against the longest, most proven, most resolute trends in the financial markets. America has recovered economically from wars, domestic civil strife, recessions and the Great Depression, then forged on to even great levels of affluence, power and profitability.

Remember: When the markets are rising, short funds will lose money. The inverse-index fund managers don’t abandon their shorting strategy to take advantage of market upturns. Their job is to continuously hew the opposite course of their target indexes, regardless of the which way the market moves. It’s your job to decide when, if ever, the time has come to put money in these vehicles.

So when you decide to short the market, you should do so only over times when you have formed a bearish opinion, or you are using a mechanical strategy that signals a market decline, and you must have a plan under which you will exit the short fund, either to prevent losses in case your opinion proves wrong, or to lock in profits if you are correct, or to move back into a long fund or money market fund as changing market conditions dictate.

Michael Sapir, chairman and chief executive officer of ProFund Advisors LLC, adviser to the ProFunds family, sums up the point this way: “We like to say that the short funds are funds that you don’t marry, you just date.”