Guest post from John Rubino originally posted on his Substack:
Today’s hot inflation number might force the Fed to tighten until it breaks something. And if past is still prologue that “something” will be the stock market.
In other words, you’re staring down the barrel of a market crash. What do you do? There are several choices. The first is to take the long view and just sit tight on the assumption that stocks always eventually go back up and trying to call the drops risks missing the big run-ups. History says that’s reasonable. But a clear reading of the mess that is today’s financial world implies that this time is different.
The second choice is to be cautious. Sell now and hoard as much cash as possible, with the intention of snapping up some bargains at or near the bottom. Most people should do this.
The third option is to play offense. Actively bet against the market (or specific components thereof) in order to profit from the “crash” part of the cycle. This is known as “short selling” or “shorting,” and people who do it are known as “shorts.” The practice has some advantages and disadvantages, and we’ll start with the bad news:
- It’s psychologically hard for most people to bet on stocks going down because we’ve been programmed to think only in terms of them going up. So your mind might rebel at the prospect.
- You’re betting not just on numbers on a screen, but on bad things happening to workers who are laid off and other investors who lose parts of their nest eggs. Profiting from and celebrating such tragedies can feel creepy, if not downright evil.
- Shorts are frequently fighting the Fed. The worlds’ governments now use stock prices as a public policy lever, boosting financial asset prices to make people feel rich and more open to spending stupid amounts of money on pointless indulgences, thus giving the economy a sugar high that lasts through the next election cycle. The Fed has effectively unlimited amounts of money with which to manipulate markets higher, which makes shorting a lot more fraught than it used to be.
- Governments hate shorts and will try, sometimes successfully, to make their activities illegal by banning or otherwise impeding the shorting of certain stocks or categories of stocks.
Now the advantages:
- Our one-sided focus on things going up is misguided, because things go down all the time, sometimes all the way to zero, making a ton of money for the people shorting them. The Big Short (movie and book) is an entertaining real-world story of people who saw the mid-2000s housing bubble as something worth betting against, did so, and (eventually, after some serious angst) ended up making life-changing fortunes. You can’t watch their story without wanting to emulate them.
- Shorting is extremely simple, similar to buying a stock you’re hoping will rise, except that you’re hoping it collapses.
- It’s not evil; just the opposite. Short sellers are the market’s truth-tellers. They point out the lies Wall Street and governments tell and bet that those lies will be revealed. When it’s done honestly, it’s good for everyone except the liars. Definitely check out The Big Short. Those guys were heroes.
- As for revulsion at profiting from others’ misfortune, it’s important to differentiate between events you cause (which you should not profit from) and events that are going to happen no matter what you do. In the latter case, not only can you short guilt-free, but you have a moral obligation to protect your family by doing so. Think Noah’s Ark.
Three simple ways
There are lots of ways to bet against stocks, but the following three are simple and relatively safe:
Shorting a stock. Open your broker’s trade window, choose a stock and a number of shares, and then choose “sell short” from the “action” dropdown. Click “place trade” or whatever term your broker uses, and that’s it. The broker will borrow the shares from another client’s account, sell them, and credit your account with the proceeds. You’ll hold those proceeds in your account until the stock drops enough to satisfy your greed, and then you’ll buy the shares back at their lower price, pocketing the difference.
It’s literally that simple, but there are some drawbacks: You have to hold enough cash in your account to cover the forced unwind of the trade. Your potential loss is the stock’s potential upside, which is theoretically unlimited. And sometimes brokers will just close out a short trade without asking permission, which for some reason they’re allowed to do.
Buying put options. A put is an option contract that gives you the right to force someone else to buy a stock (i.e., you “put” the stock into their account) for a given price (the strike price). Say a stock is trading at $10 and you buy a put on it with a strike price of $10. If the stock drops to $5, the ability to force someone to buy it for $10 is worth $5. So if you paid $1 for the put and the stock drops to $5, you quadruple your bet. Note the leverage: You’re controlling a $10 stock by betting only $1, so if things go your way the bet can return many times the original investment. Below is how a long-dated put on the NASDAQ 100 index (which includes most of the FANG tech stocks) looks in a brokerage account. Buying such a put is placing a bet that the NASDAQ 100, currently trading at $302, will drop far below $300 before January 17, 2025. That seems like a pretty good bet!
Put options have two downsides: First, they only exist for a certain amount of time before expiring, so the share price drop you’re betting on has to happen by the expiration date or you lose your entire bet. Second, the option price includes a premium to cover its “time value.” So the stock has to fall enough to offset the premium — and then some — to make an acceptable profit.
Options require a bit of study, but buying a put is one of the simplest option trades, so you can learn how to do it in a few minutes.
Buying a bear fund. There are mutual funds and ETFs that are designed to go up when the market or a target sector goes down. Their advantages include professional management and diversified portfolios of short bets. Their disadvantages are relatively high fees that eat into returns, and the sad fact that professionals aren’t always any better than amateurs at money management.
Three representative bear funds:
Rydex Inverse Nasdaq-100 (RYAIX) uses short sales and derivatives like futures contracts to match the inverse of the Nasdaq 100 Index. In other words, if the index goes down 30%, the fund hopes to go up 30%.
Grizzly Short (GRZZX) shorts a portfolio of 60 to 100 large-cap US stocks. Nice and simple, as long as they short the right stocks.
Rydex Inverse S&P 500 Strategy (RYURX) tries to match the inverse performance of the S&P 500 index using a combination of stock shorts, derivatives, and short-term government notes.
No perfect strategy
Each of the above has strengths and weaknesses, but all will tend to perform directionally. That is, if stocks in general go down, these strategies will generally go up.
PS I’m excluding leveraged 2X and 3X ETFs, which can also be used to short stocks and indexes, because they have traits that make them unsuitable for most investors (actually for all investors; they’re mainly for speculators who go in and out on a daily or weekly basis).
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