How to Short the Market with Options: Reserved for the Fearless

How to Short the Market with Options: Not for the Faint of Heart

Updated May 14, 2024

Shorting the market, especially with options, is a high-risk strategy that can lead to significant financial losses if not executed correctly. This essay explores the intricacies of shorting the market, potential dangers, and the considerations needed to navigate this complex financial manoeuvre successfully.

Understanding Shorting and Market Conditions

Shorting the market involves betting against the market’s performance by selling borrowed shares with the expectation of repurchasing them at a lower price. While it may seem tempting during a market downturn, shortening the market can be extremely dangerous. Potential losses from shorting are theoretically infinite, while potential profits are limited. As H.L. Mencken once said, “The urge to save humanity is almost always a false front for the urge to rule,” indicating the inherent risk and control involved in market manipulation.

The recent drop in volatility readings by 300 points to 10,000 may not significantly impact market volatility since the levels remain above the extreme line. If the weekly trend remains upward, this strong pullback may present a buying opportunity for top-notch stocks. It’s crucial to remember that if a stock is excellent, it can always be repurchased at a much lower price.

Market Trends and Volatility

Although the trend is currently negative on daily charts, the overall outlook remains bullish as the long-term trend is natural, with a bullish bias. As the daily trend is negative, volatility levels may remain high unless the weekly trend aligns with the monthly trend. Shorting the markets now is dangerous as the long-term trend is still bullish. It may be more prudent to use the pullback, albeit strong ones, to add to long positions.

The most likely outlook is a strong rally until the end of the first quarter 2023, followed by another corrective wave. The markets will unlikely rally to new highs during this period, especially as the trend has turned natural.

Using Pullbacks to Buy Top-Notch Stocks

The recent market downturn has not affected small-cap stocks as much as the large-cap sector. The Russell 2000, a small-cap stock index, has bottomed out and is showing a bullish pattern, with the daily trend close to turning positive. Historically, October has been known as a bear-killing month, with pullbacks followed by a reversal and upward trend. Given the current weekly trend and market dynamics, small-cap stocks have held up better, indicating a potential opportunity for investors to capitalize on this trend.

Shorting the market is for thrill-seekers. The sentiment readings and the Anxiety Index, currently in the Panic zone, indicate that shorting the markets could be dangerous unless one is nimble. Bullish sentiment has been trading below its historical average 39 for nearly 15 months, suggesting that the market could rip upwards as soon as positive news hits.

Historical Perspectives and Market Sentiment

The negative divergences continue to mount; therefore, we think the conservative investor should sit on the sidelines until some steam is released, even if it’s just a 4-5% pullback. Investors willing to take a little extra risk can continue to open up long positions. We will not short the markets until the trend turns negative in the long-term time frames (weekly charts). The trend indicator overrules everything else; thus, regardless of the pattern, if the trend says something else, we will follow the trend.

Although there was a strong sell-off in the market, the weekly trend remains up, and the small-cap sector shows signs of strength. Fear levels indicated by the VIX, XBD, and AA sentiment ratios also suggest the market has room to run. The monthly trend is currently down; unless it reverses, there is a chance of putting in lower highs. It’s too early to predict a severe correction, and shorting the markets is not advisable as the long-term trend is still intact. Nonetheless, the path up may be volatile, and changing monthly or weekly trends may lead to a correction picking up steam.

Is Shorting the Market Viable in 2024?

The current market conditions show that the markets are in the overbought range, leading to a sell-off that will likely continue. However, this is a good development for traders as volatility has increased, presenting an opportunity to buy into solid companies during sharp pullbacks. The volatility indicator has reached a new all-time high, indicating that volatility will likely stay for some time.

Investors waiting for the ideal entry points may miss the opportunity to invest in top-quality stocks. There are signs that 2024 will be a good year for the markets, and traders who take advantage of the current market conditions will benefit from this trend.

Market Sentiment and Tactical Investing

As a Tactical Investor, it is essential to remain calm and avoid panic even during volatile market conditions. The best approach is to embrace sharp pullbacks and view them as opportunities to open positions in solid companies. One should wait until all the forces are aligned in their favour, especially mass sentiment, before considering shorting the market. Therefore, shortening the market now would be disastrous for any sane investor.

Jonathan Swift once remarked, “The latter part of a wise person’s life is occupied with curing the follies, prejudices, and false opinions they contracted earlier.” This wisdom underscores the importance of learning from past mistakes and exercising caution in the market.

Random Notes on Trading and Mass Psychology

Understanding the principles of mass psychology is essential for becoming a successful investor. When the market experiences a strong pullback, we often panic and sell our investments. However, studying and understanding the psychology behind these emotions can give us the power to make better decisions. Isaac Asimov stated, “The saddest aspect of life right now is that science gathers knowledge faster than society gathers wisdom.” This quote highlights the importance of applying wisdom in our investment strategies.

Reading history books and learning from other people’s reactions is helpful to develop this understanding. Doing so can give us insight into how mass psychology can impact market trends and investor behaviour. Once we have mastered the principles of mass psychology, we can begin to identify technical indicators that appeal to us. It is essential to choose indicators based on our preferences and not just because they are famous or promoted as the best options. Once we have identified our preferred indicators, we can study them and look for patterns to inform our investment decisions.

Charlie Munger, a renowned investor, often emphasizes the importance of understanding one’s psychology when investing. He said, “The big money is not in the buying and selling but in the waiting.” This reinforces the idea of patience and strategic thinking in market investments.

Conclusion

Shorting the market with options is a strategy fraught with risk and requires a deep understanding of market trends, volatility, and mass psychology. While the allure of potential profits exists, the dangers and potential for significant losses make it a strategy not suitable for the faint of heart. As Pythagoras wisely stated, “Do not say a little in many words but a great deal in few.” This essay has aimed to provide a comprehensive yet concise overview of the complexities involved in shorting the market. Investors must remain vigilant, informed, and patient to successfully navigate these treacherous financial waters.