Why "Shorting The Market" Is So Difficult
Even if you are correct that the market is set for a correction, it is still difficult to profit off a system that is designed to go up.
“The Big Short”, is a movie centered around investors that made large bets against the US housing market. One of the main characters in the movie is Michael Burry, played by Christian Bale. Michael Burry is a famed investor and hedge fund manager who began to notice as early as 2005 that the housing market was due for a swift correction. Michael Burry approached banks and began to “short” the housing market via “swaps”, which were essentially insurance against mortgage back securities. Mr. Burry would profit if the housing market began to fall and the value of the mortgage bonds began to suffer. However, in order to keep the “insurance” against the mortgage bonds, Mr. Burry had to pay a “premium” every month to keep the insurance policy alive.
Since Michael Burry began shorting the housing market via swaps in 2006 and the housing market did not endure a significant correction until mid to late 2007, Michael Burry was bleeding premium for almost 18 months. Meaning, he had to pay the banks who were holding his “insurance policy” every month or he would lose the policy. His fund was losing so much money that he ended up having to sell some of his insurance swaps against the mortgage bonds to continue to pay the premium on his remaining swaps. Eventually the housing market began to correct and Mr. Burry made a 500+% profit and went on to become extremely famous. The perils faced by Michael Burry, even though he was ultimately correct that the housing market would fall, should be a cautionary tale to every investor.
Investors buying put options on the market indices face a similar challenge. Although I have made a lot of money by shorting the indices in March, June and September of 2020, I have also come to realize the serious difficulty in making money on the “short side”, betting against the market.
The first hurdle for short-sellers is timing. Like Michael Burry, you can be completely correct that the stock market is likely to correct, however, it is impossible to time. The tech bubble in the Nasdaq became obvious to investors in late 1998, but it took until March of 2000 for the bubble to actually pop. Even if you were “right” in 1998 by sensing the market was likely to fall, buying put options on the Nasdaq at that time was a guarantee you would lose money. Remember, when buying an option, theta is your main enemy. Theta, is the rate of decline in the value of an option due to the passage of time. Meaning that, a put option bought in January, with an expiration date of October, is much more valuable in February than in September. The reason for this is that the put option is much more likely to expire worthless in September than in February. There is much more time for the put option to reach the strike price in Febuary (6-7 months away) versus September (one month away).
The second hurdle is government intervention. Pensions, retirement funds, and the livelihood of many members of Congress are directly tied to the price of the stock market. Whenever the stock market begins to correct and the news media starts airing stories about the market correction, there is always an immediate cry for the government to help fix the problem. This prompts the Federal Reserve to act and use the entire power of their printing press to help prop up the stock markets by lowering interest rates and even buying securities such as bonds. The government also takes drastic measures such as banning short selling on certain companies and using their political platform to assure investors that the markets will recover. As one has seen over the past eighteen months, this is a nearly impossible force to overcome. In 2008 and in 2020, the Fed has overcome what could have been a complete market collapse by simply printing their way out of the problem. The ramifications of that decision will be seen over the next few years, unfortunately.
The final hurdle is passive market flows. In the 1980’s, Wall Street, with the help of large corporations were able to convince Congress that the best way for workers to save for retirement was not corporate guaranteed pension plans, rather it was for workers to invest their money in a tax-advantaged investment account called a “401-K”. This movement allowed corporations to off-load the liabilities of pensions and provided a whole new pool of money to flood into the stock market. Most of these 401k plans are set on automatic paycheck deductions, where every time an employee is paid his or her money gets invested into the market via a mutual fund or passive investing index fund. These employees buy into stocks every month, regardless of valuation, market fundamentals, or economic climate. This automatic investment ensures that the market always is being bought even at times where it seems no rational investor would invest their money in stocks.
These forces make it extremely difficult to profit by buying put options on the indices. If you are going to buy put options in an attempt to bet against indices I highly suggest you choose a long-dated put options, one with an expiration date at least nine months out. Secondly, if the put option becomes profitable, sell it. It has been difficult to sell my put positions when I have a slight gain, because I think the market will continue to go down, however, for the above-mentioned reasons, you will likely get crushed. If you buy put options and make a decent profit, SELL. The other option is to just hold cash and wait for a correction to buy up assets on the cheap.
As Always, Happy Trading!
** This article is for entertainment purposes only. This is not investment advice. For investment advice please consult with a licensed financial advisor.**