There are two key ways to make money during a market downturn, or what some analysts and investors call a “stock market crash.” When sellers greatly outnumber buyers, prices naturally drop, because buyers know they can obtain something of value for a lower than normal price if the seller is motivated enough. The reverse is also true. When there are more buyers than sellers, prices climb because sellers know they have an advantage.
In the modern electronic age, a “crash” is most likely driven by electronic thresholds, which interpret a moderate dip in prices as a potential for a large decrease. These electronic systems then sell shares automatically to avoid a loss of captial, which further decreases prices and creates a negative feedback loop. The same kinds of dynamics exist when individuals are in control. The fear of losing valuable capital drives sellers to accept what they can get in lieu of possibly getting far less.
There are two relatively safe basic strategies for making money in a down market.
If the underlying fundamentals of a stock are sound, and the market is reacting to inaccurate or misinterpreted information, one of the best ways to profit from a downturn is to buy in tranches as the price falls below certain milestone prices. For example, if a stock starts at $60, a shrewd investor could buy lots at $55, $50 and $45, banking on the price rebounding at some future point. The reason for buying at different price points is to hedge against the possibility of future fluctuations. The $45 shares are far less vulnerable to price drops than the $60 shares, and they are also the shares that will produce the highest returns when the price recovers.
A call option is a contract giving the buyer the right to buy a stock at a pre-determined price on or before an expiration date. The only limit on how much money can be made with a stock option is the price paid for it. If an investor can gauge the floor on a stock’s price, again given the underlying fundamentals of the company are sound, then that investor could negotiate the right to buy shares at or near the floor. If the option is long enough, it could give that investor the ability to buy future shares of a stock rising in price after the market downturn, but at the floor-level price negotiated when the price was falling.
It is possible to lose on options, especially if the negotiated price is too high and leaves the option buyer with a stock that can’t support the purchase.