As a result of fundamental logic and behavioral observations, profiting off single stock failures has historically provided more return potential than the upside. With every bearish period a number of investors and put option writers tend to take large draw downs or devastating blow outs. Remarkably, the downside biased traders have survived bullish times, and made fortunes as the general optimistic public took overwhelming losses.
Rationality of Negative Partiality
It takes discipline, flawless collaboration, and hard work for corporations to achieve success. Game theory asserts that individual and group interest conflicts occur ceaselessly, like that of employees versus employers. The execution level workers take more interest in paycheck sizes than corporate income, a result of collective labor, and vice versa for the management level staff. The existence of this divergence in motivation makes performance optimization difficult if not impossible.
Product Cycles Always End Downward
New products do not carry high probability of making a profit. The successful ones experience typical cycles of growth and the inevitable decline and demise. For the price of equity to increase continuously and limitlessly, corporations must keep public sentiment collectively and consistently positive with every single product launch. Statistically, the average company will never go through this level of success.
No Guarantee of Repurchase from Sellers
Equity holders eventually liquidate positions to take profit or limit loss, and vice versa for short sellers. The initiated sell orders lower liquidity which causes negative price impact; and the original sellers may never repurchase the same stock(s). The next wave of sellers must then lower prices further to attract new willing buyers. At any point in time, the amount of equity holders outnumbers short sellers, this leads to an edge for negative bias.
Price Drops Carry Higher Volatility
Volatility, or speed of price movement, tends to elevate more often in sell-off periods. This observation concurs with the notion above that liquidity becomes an issue for sellers and not buyers in general. Emotional response also plays a role. Traders might panic trying to rid of undesirable positions and lower prices more willingly with bargain hunters.
Ease of Financial Statement Research
While corporate accounting has become known to tweak numbers and make performance appear fantastic, they have much less incentive to feign failure. The Enron or WorldCom types of shenanigans become completely mitigated in this approach. With the negative partiality, horrible performance points to great trading profit potential.
Techniques of Downside Betting
1) Short Selling - This is the most straightforward position to exploit equity price drops.
2) Long Put Option positions - A long position with a put option provides more potential return than short selling as it provides leverage and increase in value along with volatility which often accompanies underlying price declines.
3) Option Synthetic Position - A long put option and a short call option at the same strike price. The change in value of the underlying will become equivalent in this option spread.
Last Words
The presented scheme here proposes only a theoretical edge, and should not be implemented without additional research and adequate risk management. The world of finance offers a dynamic, treacherous path, where an open mind and diligent learning become essential.
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