Shorting a stock means borrowing it from another investor to sell at prevailing market prices. If the stock price subsequently declines, you can buy back and deliver the shares to the original owner for less than the sales proceeds. The difference between the sales proceeds and replacement cost is your profit. In addition to shorting individual stocks, you can also short an index, such as the Dow Jones Industrial Average. Since you cannot directly buy or sell an index, however, you would employ slightly different strategies to do so.
Using futures contracts is one strategy to short the Dow. A futures contract is an agreement to buy or sell something at a predetermined price on a future date. For example, suppose you agree to purchase 1,000 tons of corn at $50 per ton on December 1. If the market price of wheat is above your purchase price, you can sell your wheat at an immediate profit. In a Dow futures contract, the buyer and seller agree to exchange cash based on the future index level. For example, for every point the Dow exceeds 14,000 on December 1, the buyer might receive a dollar from the seller. The seller would receive a dollar for every point the Dow is below 14,000 on December 1.
Options are similar to futures, with one major difference. While futures contracts are legally binding for both parties, the buyer of the option has the right to refuse the predetermined exchange if doing so is financially disadvantageous. Call options let you purchase if you so desire, while put options allow you to sell. A put option on the Dow with an expiration of December 1 at 14,000, for example, will allow you to collect money for every point the Dow is below 14,000. If the Dow is above 14,000, however, you pay nothing. To attain this privileged position, you must pay cash upfront to purchase an option, whereas futures contracts require no upfront payment.
An ETF is an Exchange Traded Fund you can buy and sell just as easily and with the same low commissions as stocks. A long ETF that mimics an index advances at the same percentage rate as the index, while a short ETF advances when the specific index declines and loses value when the index advances. The financial managers in charge of the short ETF employ several strategies to ensure that the ETF value moves in the opposite direction to the underlying index. One such ETF is the ProShares Short Dow30, which trades under the ticker DOG.
For investors who can stomach the risk of a risky trade, there are leveraged ETFs. These funds move up and down twice or three times as much as the related index. For example, the ProShares UltraShort Dow30 moves in the opposite direction of the Dow, but with twice the magnitude. If the Dow is up by 1.5% on a particular day, the ProShares UltraShort Dow30, trading under the ticker DXD, wil be down by 3%. A 1.5% decline in the Dow, on the other hand, will send the value of the ProShares UltraShort Dow30 up by 3%.
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