Who Profits From Stock Market Corrections?

Investors know that periodic stock market setbacks and corrections are normal, yet most dread them. Investors can profit from market declines by shorting stocks, yet few do. Some accept corrections as a necessary evil, some panic and sell, with most losing money during market declines. But when investors sell shares in a correction, who is buying? Are the buyers stupid or reckless, or do they know something other don't? Does anyone other than shorts benefit from corrections?

Let's say your house is worth $400,000. 10 years ago you paid $200,000 for it so you can't complain although at the height of the real estate market the house was worth close to $600,000. You are planning to stay in the house long-term, whether it appreciates or not in the future. But wouldn't it be nice to be able to make some money on the house while living in it, especially if real estate prices are not moving?

Trading vs, Investing

Suppose you could incorporate your house and issue 10,000 shares of stock worth $40 each that would trade in the open market. As long as you retain a 51% ownership, or hold on to 5,001 shares, you are in no danger of losing the house, so you can safely speculate with roughly $200,000 of it by trading the newly issued stock.

If the shares in your house remain at $40, you won't be able to make a profit, but if they fluctuate between, say, $30 and $50, you could buy each time they went down and sell each time they went up. You would want them to fluctuate, the more the better. Imagine how much money you could make trading your house between $30 and $50 per share year in and year out. The bigger the price swings, the more money you'd make. Not only would you not dread corrections, you would welcome them, because they are your best opportunities for buying low.

Buy Low, Sell High

Substitute a corporation for your house and the 10,000 shares for 10 million - and you get the picture. Insiders and large investors are simply buying low and selling high, over and over again. They are confident that the stocks they trade will come back - because they control the company, or the stock, or simply because they have inside knowledge, so they use market advances to sell high and market corrections to buy low. Over and over again. Pretty simple.

This, of course, is a simplified picture: many insiders and institutions lose money in corrections as well but that does not negate the fact that at the core of profitable stock investing is the smart money that sells when you buy and buys when you sell, especially during corrections.

More from this contributor:

Buy Low, Sell High - So Why Don't You?

How to Make 50% in a Correction with Little or No Risk

Fear: The Primary Driver of Market Corrections