Folks, we are in the midst of a massive NASDAQ bubble. Tech companies—especially social media companies—are overvalued at a level not seen since the dot-com crash of 2000. Just as many folks got rich in that bubble, many others lost a lot of money betting on Pets.com or EToys.
There are a couple ways to profit from a stock going down. One way is to "sell short." This is when you borrow a share of stock, sell it, and then buy at back a later time to pay back the share. If the share goes down, you make most of the difference between your initial sell and your "buy to cover." If you have a short position and the company goes bankrupt, you never have to pay it back, and your pocket all of that selling price as profit (after fees).
The problem I have with this method is that the gains are limited to the current price of the share, and the potential losses if the share goes way up are unlimited. If you sell a share short at $50, the most you can make is $50. But if that share price goes way up? $200 $300? There's no limit to how much you could lose as you bought a $400 share to cover what you sold at $50.
Because of this asymmetry between finite gains and potentially infinite losses, I prefer a different method to benefit from declining stocks. This method uses stock "options" which are considered a derivative because they derive their value from something else.
Options are just the right to buy or sell a given stock for a given price before a certain date. There are lots of terms that go with these, but that's the high level view. The right to buy is called a "call." The right to sell is called a "put". The price at which you buy or sell is called the "strike price."
By buying a "put" option—the right to sell—that expires far into the future, you can not only profit more than just using a regular stock, but the potential gains can be substantial while the risks are limited.
Let's say you find TWTR to be a great candidate to crash and want to profit from that. The current price of TWTR is about $50/share. The right to sell for $25 by January of 2015 may cost only $1.20 per share.
What happens if the share price drops to $30? That right to sell will go up in value to $8 or $10. That means you have earned 600% return or more on your money—having spent $1.20 to sell for $8 or so.
Meanwhile, the most amount of money should could possibly lose would be your original $1.20 by just letting the options expire unexercised.
There are many, many companies poised to crash in this tech bubble—Twitter is one. Facebook may be another. LinkedIn almost certainly. Zillow. Netflix. Etc etc.
The problem is not that there's no way to profit from this coming crash—the challenge is determining which is the most lucrative bubble that will pop.
Finally a warning—stock options are far more volatile than regular share prices. Do not invest in stock options unless it is with money you can afford to lose without endangering financial security. Unless you can handle swings of perhaps several hundred dollars in a given day, options investing is probably not for you.
If you are in a position where you have a couple hundred dollars available to turn into much more money, then buying some put options on overvalued social media/tech companies is a great way to profit from a likely bubble pop.