July 28, 2024 | From the Archives: How to Short Stocks – Is it finally time??

First, the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) were going to rise forever. Then they morphed into the “Magnificent 7” which many believe will ride the AI boom to infinity and beyond. Either way, the result is a wildly unbalanced market (and economy) supported by a tiny group of multi-trillion-dollar companies.

We’ve seen this play before, and it always ends the same way, with an epic crash. It’s just a matter of when.

But therein lies the problem: Betting on overvalued stocks to crash can look like a no-brainer (“It’s trading at 25 times sales! Nothing can live up to that valuation!”). But financial bubbles often experience spectacular blow-off tops before they die, which kills off most of the “shorts” who had previously bet on a crash.

That’s what happened to my “short the Nasdaq and the homebuilders” recommendation of February 2023. A year and a half too early is dead-wrong in the world of shorting.

Is Now the Time?

Here’s the original “how to short” post, with a few updates to match the current time frame:

Crash-Proof Your Portfolio: How To Short Stocks

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. 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 probably 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 latter:

• 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 selling it and hoping it collapses.
• Shorting is 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 done honestly, this is good for everyone except the liars. Again, 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 (from which you should definitely not profit) and events that will 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

Short 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.

Buy 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 Big Tech stocks) looks in a brokerage account. Buying such a put is placing a bet that the NASDAQ 100, currently trading at $462, will drop far below $450 before December 18, 2026. Right now, that seems like a pretty good bet!

John Rubino July 28th, 2024

Posted In: John Rubino Substack

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