3 Ways to Short the Stock Market and Not Get Killed

With central banks still firmly in the economic driver’s seat and US data continuing to look healthy, it would seem the only thing to do is buy the stock market. At the same time, an uninterrupted (mostly) five year bull-market has left the stock market near the top end of its historical valuation. While investors such as pension funds have no choice but to chase returns in this zero interest rate environment, some have turned bearish on the market.

Contrarians expect mean reversion in profits and prices as the FOMC removes stimulus. But shorting a rising market can be dangerous for your economic well-being if not done correctly, and today we look at three strategies which can be used to make money off of market declines and not hurt you badly (or even leave you with a profit) if markets go up:

  1. Ratio put spread – Sell 1 at-the-money (ATM) put, buy 2 or more out-of-the-money (OTM) puts at a lower strike
    • The idea here is to sell an ATM put to finance 2 or more OTM puts
    • You should only do this if you are receiving a net credit (i.e. if ATM put price >= N * OTM put price)
    • If the market stays the same or goes up you keep your net credit
    • If the market declines slightly you could lose on both your ATM and OTM puts (worst case scenario is stock settles at your lower strike)
    • If the market declines a lot you will make more money on your excess OTM puts than you lose on the embedded short put spread.
    • This position does best when the market declines a great deal, and is neutral to market rallies, worst case occurs with a small decline in the underlying
    • For example suppose XYZ is at 100 and the 100 Put is 6.0 and 90 put is 2.0
    • We would sell 100 Put receiving $600 and buy 3 90 puts for $600 for a net credit of $0
    • If XYZ is at 100 or above at expiration, we make $0
    • If XYZ is at 90 at expiration, we lose $1000 (worst case scenario)
    • If XYZ is at 80 at expiration, we make $1600
  2. Reverse Condor – Buy both a call and a put spread straddling the market
    • This strategy is similar to a straddle, in that the market could move up or down and make the position money
    • Selling OTM options against the core straddle position decreases the cost of the position at the expense of capping upside profit potential
    • Depending on your personal skew to the market, you can experiment by having a more or less aggressive spread on the up/down side of the market
    • For example, suppose you think there is a chance of a large decline but a high probability of the market moving higher
    • You could buy a near the money high delta call spread, this would make/lose money immediately from any rises/falls in the underlying stock
    • At the same time, you could purchase an aggressive (and hopefully cheap) OTM put spread that only makes money if the market declines by a significant percentage.
    • Thus if the market grinds higher you make more money on your call spread than you lose on your cheap put spread
    • But if the market declines by a lot your put spread will make multiples of the money invested and make up for the call spread losses.
    • The idea here is to finance your put spread from the sale of your OTM call. That way you make money in market rallies but more than hedge yourself on the downside if a big move results.
  3. Reverse Calendar Spread – Buy a near term put, sell a longer term put at the same strike
    • This is the opposite of your typical calendar spread in that you are buying the near term option instead of selling it
    • This strategy profits from large moves in the underlying in either direction before the near term expiry
    • Interesting, the strategy is both LONG gamma and SHORT vega, meaning it will benefit from both falls in implied volatility and large short term moves in the underlying.
    • This strategy is best to use AFTER a rise in implied volatility (after the decline has started) when you aren’t sure if the market will rebound or continue to fall
    • This would have been a good strategy to use on October 15th when it wasn’t clear whether we were heading to zero or about to bounce. Implied volatility collapsed after the market rebounded which would have made the position a profit even though we were betting on a decline.
    • The worst case scenario for this strategy is if the underlying goes nowhere and implied volatility remains high in the long term.
    • A downside to this is the large relative margin requirements necessary to establish the short long term option.

3 replies »

  1. no prob. just a follow up, these 3 strategies were formulated assuming a flat starting position (or at least looking at their performance in a vacuum). these strats have some upside delta baked in to compensate for a rising market scenario. for those already long, that exposure might be redundant. in general, longs can protect themselves using strats like covered calls or otm put purchases.

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  2. Sorry quick follow up Q.

    How many DTE do you usually go for in the above examples? Then Jan ATM put (15 DTE) on SPY would require you to go all the way to 200 to receive a net credit. Feb would require you to go down to 195 (larger max loss exposure)

    Opinion on efficiency of these methods below for those who are long as they carry slightly negative deltas.
    1) Purchase ITM Put LEAP and finance it by the sale of monthly OTM Puts such that annual OTM premium recovers cost of the LEAP. (Diagonal spread where we purchase back month)
    2) Simple put vertical spread on SPY and roll monthly?
    3) vertical Spread on VIX Calls? (Though not a perfect hedge to market, I assume large crashes correlations go to -1)

    Your expertise is greatly appreciated

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