There are simple ways to make money when stocks drop using more traditional investing methods and there are also more advanced strategies to make money when stocks drop.
In this post, I will cover simple to slightly advanced strategies that both investors and many wealth managers use to make money in down markets for their clients.
What Is the Difference Between a Correction and a Bear Market?
When stocks drop one of two events happen.
- A stock market correction is a drop of under 20%.
- A bear market is a drop is of 20% or more.
Since corrections are fairly normal events that happen every year or two, most investors just ride them out to avoid getting whipsawed if the market suddenly changes course.
But when stocks drop to that bear market level of 20% or more, smart investors have strategies in place to protect protect their investments. And proactive investors even make money from the drop in stock prices.
Simple Ways to Make Money When Stocks Drop
There are several ways prepared investors can make money in down markets. These strategies more or less mitigate risk in an overall portfolio and by making money from other assets or strategies. Keep reading and I’ll explain.
Own Assets That Go Up When Stocks Go Down
The simplest way to make money when stocks drop is by owning investments that go up when stocks go down. While this sounds overly simplistic, this philosophy is at the very core of asset allocation investing.
This is the model most investors and financial advisors use. It works best for patient investors that are happy with the returns from this method.
With asset allocation investing, a percent of a portfolio is invested in quality bonds, often U.S. Treasury bonds. Low risk bonds almost always go up when stocks drop allowing investors to make money from the price increases in their bond investments.
When you own a diversified portfolio of stocks and low risk bonds you are hedging against stock losses within your investment portfolio.
Read my related post with more detail on how often bonds go up when stocks drop based on history, my favorite investing tool.
As always here at Retire Certain, it’s important to begin with your goals. If it is to mitigate losses in a down market with minimal effort, making money with at least a portion of your portfolio (in bonds) this method may work well for you.
Learn more about asset allocation in my post How to Understand Your Investments.
Does Gold Go Up When Stocks Drop?
Another asset that is thought to go up when stocks drop is gold. Gold is, however, a less reliable way to make money when stocks drop since it has not gone up as consistently as bonds have during past bear markets.
Read more about this in my post What Goes Up When Stocks Go Down?
Buy Cheaper Stocks
Everyone dreads bear markets but here’s what’s great about bear markets. When stocks drop, you can buy the same stocks for much less than they were before the bear market began, often for over 50% less! Investors can make money by selling the stocks later for capital gains at higher prices. Or investors can hold the stocks to increase net worth through unrealized capital gains.
Read more about this in my post How to Avoid Losing Money in the Stock Market
This sounds so ridiculously simple but it’s not. Most investors don’t buy at lower prices because it’s scary to invest when the stock market has fallen 50%!
Following the herd feels safer, which is covered more in my article entitled How to Know if the Stock Market Will Go Up or Down.
Buying cheaper stocks can be done on the way down, or it can be done after the market has big declines and is coming out of the bear market, depending on your risk tolerance.
Sell Covered Calls
After stocks have dropped to bargain prices, and you’ve bought cheaper stocks, you can sell covered calls on those stocks. This allows you to make money from call option income.
This strategy is more for patient investors who want to make money after stocks have dropped significantly. That’s because a covered call strategy work best after the stock market has bottomed and stocks are trending sideways or back up again (unless you own inverse ETF’s as covered below).
Here’s what is great about selling covered calls right after a bear market.
- Very high quality stocks are super cheap.
- Selling covered calls after a bear market is more profitable than normal because the income you get from the option premiums is higher than normal due to increased volatility.
Volatility and Bear Markets
Here’s one important concept when considering the best opportunities to benefit from a bear market. Volatility increases when stocks rise and fall on high volume.
And when volatility increases, option premiums increase. This is good for option sellers (and it’s bad for option buyers.)
But aren’t options super risky? Selling covered calls does not increase the risk of stocks, contrary to what many investors assume when they hear the word “options”. Actually, selling covered calls lowers risk since the call income offsets the purchase price of the stock.
There is risk inherent on owning stocks and selling covered calls lowers risk. Read my article How Do Covered Calls Work? for more on this.
Smart dividend investors know that dividends keep rolling in even when the stock market drops. While, admittedly, the drop in your stock portfolio is painful, dividends can help relieve that pain.
But let’s be real. Dividend stocks that yield 1.5% (before inflation and fees!) are much less soothing than dividend stocks yielding 8%! Read more about this in my post Is Dividend Investing Worth It?
While dividends won’t offset the loss in value from bear markets, the income will at least partially offset those declines.
Again, this all goes back to your personal investment goals and whether you are aiming for investment income or capital gains. I like to go for both.
Don’t forget, you can also sell covered calls on many dividend stocks.
This related post, Are Dividends or Capital Gains Better? expands more on this.
Advanced Strategies to Make Money When Stocks Drop
Many proactive investors and wealth managers use advanced strategies to protect their stock investments that also make money when stocks drop.
These advanced strategies can be complex and difficult to implement so they appeal only to proactive investors willing to spend the time and effort to learn and manage them.
Inverse Stock ETFs
It can feel like everything drops when stocks drop and many assets do! But inverse stock market ETF’s move in the opposite direction of stocks. In other words, when the stock market is falling, inverse ETF’s are rising. Some riskier inverse ETF’s are leveraged and they represent 2 to 4 times the market move!
As you can imagine, inverse ETF’s soar as stocks drop.
Note that covered calls can also be sold on inverse ETF’s making this a way to make money when stocks drop from two different strategies but with the same investment capital.
The timing can be very tricky with inverse ETF’s making them only suitable for very experienced investors or financial professionals. Many bear market funds use this strategy to make money when stocks drop and even they are wrong at times.
While unleveraged inverse ETF’s can work well for some investors, I always like to remember that the stock market rises more than it drops over very long periods of time. As a result, inverse ETF’s require an element of timing.
Another strategy common among financial professionals and proactive investors that makes money when stocks drop is appropriately called a protective put. Here is how a protective put works.
Like a call, a put is a type of option. Think of it as the opposite of a call option. A put option gives the owner of the put the right to sell a stock to the option buyer at a defined price, called the strike price. Additionally, the stock must be bought on or before a certain date, called the option expiration date.
Here’s the thing: put options move in the opposite direction of the stock market. In general, when stocks drop, puts go up.
Remember from above, that the price of options rises when volatility rises. Again, this is good news for option sellers, but bad news for options buyers, making protective puts expensive insurance.
Some put options represent the overall stock market, such as the S&P 500 index. There are also puts that represent individual stocks.
So, inverse stock ETF’s and protective puts are two common ways to make money when stocks drop. But inverse ETF’s actually make money when stocks drop. On the other hand, protective puts simply offset the drop in value from owned stocks because the puts increase in value but the stocks have dropped in value.
Naked puts are a popular strategy for experienced option traders during stock market drops. Naked puts can work well for investors who want to own stocks anyway but there is a huge caveat.
Here is how naked puts can make money when stocks drop.
“Naked” just means the puts are sold without the option seller owning the related (“underlying”) stock.
Instead of buying stocks outright, investors sell puts. They get to keep the income from selling the put regardless of what the stock does, which is pretty cool.
Here’s the caveat: If the stock drops below the put strike price, the stock will get “put” to the put seller, meaning, the put seller has to buy the stock. If the stock price rises, the put option will expire worthless, something all naked put sellers love.
You can see how naked puts can be risky during down markets that are continuing to fall. A stock can get “put” to a seller and the stock price can fall another 30%.
But let’s keep this in perspective. Most stock investors “ride out” market declines of over 50% anyway.
Again, naked puts work best for investors who want to buy stocks anyway and are ready to do so with available capital allocated for buying stocks.
The reality is that like all investments, naked puts can make money or lose money overall. Other option strategies that use a “collar” with another option are lower risk than naked puts.
Simple Vs Advanced Ways to Make Money When Stocks Drop
Now you have seen several ways to make money when stocks drop during and after bear markets.
While owning bonds can be an excellent and simple way to make money when stocks drop, they are less than ideal investments during bull markets due to low insanely interest rates and inflation erosion. Investors can be stuck owning bonds for years before a bear market finally hits. While the risk reduction is valuable, bonds can be a serious drain on portfolio performance.
At this point, I like to avoid overvalued investments, in general, and increase cash as stocks get overvalued. Undervalued assets or stocks that pay high income can be a good investments since the income is nice to have.
Sometimes having higher levels of cash has cost me when the high flying stocks continue to soar longer than I thought they would, but I have chosen the type and amount of risk I want at various times in my life.
After decades of investing through both up and down stock markets, I have learned that choosing the level of stock market risk I want allows me to invest better and be more at peace.
Summary for Avoiding Stock Market Losses
Even though investors dread inevitable bear markets, as you can see, there are many ways to make money when stocks drop.
Some require advance portfolio preparation.
Some are more portfolio protection than money making strategies.
And some work before stocks drop while others work only after stocks have come through the other side of an outright bear market.
Insightful investors recognize bear markets as opportunities to make money when stocks drop.
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