Why Shorting the Market is A Bad Idea
By Lucas Sherbrook
Shorting the stock market has been a very popular pastime of some retail investors, and from time to time huge returns are made from the lucky OTM put option. While it can be lucrative to short the market from time to time, and there are multiple ways to do it, it will always end up as a losing position in the long run. I will be going over each type of shorting and then stating why it is a bad idea.
There are several main ways for the normal retail investor to trade against the market. The traditional way to short the market is by short selling stocks and ETFs. This requires borrowing the shares from a current holder for a certain percentage fee, selling the stock on the market, and buying to cover the short position later. The difference between what you sold the stock at and what you bought the stock at is the profit or loss. As stated, there is a cost for shorting the shares. This is paid on a daily basis and depends upon the demand for borrowing shares. Sometimes when the demand is extremely high, the cost of shorting can reach insane amounts, as it did with Nikola Corporation when the shorting rate went above 1,000%! This means that at that rate you would have to pay 10 times the value of the shares in a year if you were shorting that stock. Considering that the most you can make by shorting a stock is 100%. Furthermore, there is technically infinite risk as there is no cap to how far the market can move upwards. If the market moves too far upwards, there is also the risk that you will be margin called by your broker. This means that the broker has the right to force you to close your short position and sell your other assets to cover the loss. Because you are only borrowing the shares, you must pay dividends to whoever you borrowed the shares from. This may not hurt you for some high growth stocks (even though the high growth will), but for high dividends stock, this could potentially leave you with almost no hope of being profitable.
The easiest and one of the least capital-intensive ways is to bet against the market is by buying an inverse ETF. An inverse ETF is an ETF that uses financial derivatives such as swaps to maintain a negative position on the market. Oftentimes these ETFs are leveraged, meaning that the normal daily market movements will be multiplied by the leverage amount. Two examples of this are SDS (2x) and SPXU (3x). The benefit of holding these positions is that a margin account is not required, and it is impossible to lose more than you put into it as it is with traditional shorting. The problem with inverse ETFs is that they will almost always underperform what they are intended to do. This is caused by two main reasons: the cost associated with swaps which can be as high as 1% and the cost of volatility decay. Market volatility generally peaks during a downward market which is right when inverse ETFs are supposed to be making the most money. Inverse ETFs rebalance on a daily basis which means that they begin each day not affected by the day before. This will cause them to lose value as the market goes up and down day after day for mathematical reasons. The expense ratios of inverse ETFs are usually extremely high as compared to those of normal ETFs. SPXU has an annualized return of -42.6% over the last 10 years.
Options are also another popular way of shorting the market because they generally have defined risk, offer very high leverage, and allow for an extremely high amount of flexibility. Because of the flexibility of options, I cannot go over all the shorting the market strategies using options, but I will sufficiently prove my point. One of the more simple and widespread ways is by buying a naked put on the stock/ETF. While this can lead to very high returns, usually it is going to prove to be a very good way of losing money. Options cost a certain amount known as a premium. The premium depends on several factors including the price of the stock compared to the option strike, the time left until expiration, and the current market volatility. Over time as the option becomes less likely to move into the money, the option will lose value. For traders longing options, this is a constant friction. If the option is not in the money at the time of expiration it will become worthless. Also, the options price in relation to the market’s volatility is only a best guess at what the volatility will really be over the option’s life. Usually, volatility is overestimated which means that the price of the option is higher than it should be. Furthermore, options generally cost higher commission than stocks and there is lower options volume which creates wide bid-ask spreads which will only add to the losses. Even if a retail investor finds a winning strategy, he will still have to size his positions properly. With great leverage comes great responsibility. The farther out of the money you buy options, the less money you can allocate to that position without risking be wiped out by one unlucky trade. Oftentimes option trading amateurs over-allocate to a position and lose too much or all of their portfolio. There are some options strategies that include debit and credit spreads and synthetic positions that may find some better results, but in the end, it is likely to go the same way.
Selling index futures is another way of shorting the market; however, due to the account minimums, contract sizes, and the more complex nature of futures, this is one of the lesser common forms of shorting. The advantage of shorting the futures markets is that there is no borrowing fee and no dividends risk. Futures also allow for high amounts of leverage, though this can also lead to more risk. The problem with futures is that equity index futures generally are in a state of backwardation. This means that the further out in date the futures contract is, the lower the price is that the contract trades at. As the futures contract moves more towards the expiration date it raises in price until it meets the price of the actual index right before expiration. The reason that the futures prices are lower than they should be is because they take into account dividends and the cost of carry (so in the end you are still paying for dividends). It is interesting to note that shorting other futures such as gold and oil may actually be a good trade as those markets are generally in contango which means that the price of the futures becomes higher the farther out in time they are (meaning that they lose value over time).
The nail in the coffin for shorting the market in any form is that the market always goes up on average. While basing the future on the past is not always a good idea when it comes to stocks, it is fairly safe to say that the market will probably continue to do so as our economy grows and the higher risk of the stock market when compared to other asset classes requires higher reward. This means that shorting the market is a losing proposition no matter how you try. One may say that it is possible if done for short periods of time. Yes, while it is necessary to only hold a short position for a limited amount of time to have any hope of being profitable, this is also a losing position on average. If the market goes up on average 10% per year, then it is mathematically safe to assume that it goes up continuously throughout the year. The more times that you attempt to create a short position, the more likely that you will lose money overall, just as in a casino. Furthermore, due to market efficiency, it is impossible to know during what period the market is going to fall in the future. The market’s upward movement mixed with every other cost of shorting makes for a highly unprofitable experience.
There are some things that a retail investor can do profitably when they feel that the market is overpriced rather than shorting. The first and most simple is just to hold cash. This will probably lead to opportunity costs, but there will be no realized losses and if the market does go down you can buy in at a lower price. It is also possible to take more neutral bets on the market using options. If you believe a stock or the market is overpriced but there is a lower price you would be willing to buy in then sell cash-secured put options at the strike price that you would be willing to buy at. This will give you an option’s premium and a margin of error.
I hope I have made it clear that betting against the market is a bad idea. No matter if you are shorting in the traditional way, buying inverse ETFs, buy put options, or shorting index futures, you are bound to lose money. Even if you do manage to make some money regularly shorting the market, it will almost surely have underperformed the market and taken much more time and energy than buying an index fund.