I have a secret to share. I am going to tell you the single best way to short the market - a way that investors have yet to take advantage of. How do I know that investors aren't doing it? I'll explain that later in the article.
So what's the single best way to short the market? You might think it's shorting the SPDR S&P 500 ETF (NYSEARCA:SPY) or buying the ProShares UltraShort S&P 500 (NYSEARCA:SDS). Given the slightly higher betas associated with small-cap stocks, perhaps you would be tempted to name a short position on iShares' Russell 2000 Index Fund (NYSEARCA:IWM) as the best way to short the market.
If you are short the market via one of the aforementioned funds, you may also be interested in a different way to make money shorting the broader U.S. stock market. But before explaining further, let me first state that for the purposes of this article, "best" does not refer to "safest." If you are short the broader U.S. stock market but don't have a lot of conviction in your belief, there may be safer alternatives than what I will describe.
For those investors looking for the biggest bang for their buck when shorting the S&P 500 and for those investors with some serious conviction in their beliefs, the single best way to be short is by buying deep in-the-money put options on the Direxion Daily S&P 500 Bull 3x Shares (NYSEARCA:SPXL). Given that there are leveraged funds that track the inverse price performance of the major market averages, I would guess that many investors have never thought of using a leveraged long ETF as a means of getting short the broader market. But they should. And here is why:
SPXL's objective is to seek daily investment returns, before fees and expenses, that equal 300% of the price performance of the S&P 500. If you purchase puts on this fund, you are making a bearish bet on a fund that tracks the S&P 500 by three times its daily return. So why wouldn't you just purchase the Direxion Daily S&P 500 Bear 3x Shares (NYSEARCA:SPXS) instead? It has to do with the leverage associated with these funds. Leveraged funds are known for suffering from slippage. In other words, over periods longer than a single day, investors should not expect the performance of the ETF to track that of the underlying index the way it does over the course of a single day. As an example, see the table below:
3x Leveraged Long ETF
If the S&P 500 rises 3% from Day 1 to Day 2, a corresponding three times leveraged long ETF, such as SPXL, will rise 9%. In the table above, I start with an ETF share price of $100 for simplicity's sake. If on Day 3, the S&P 500 returns to 1,400, falling 2.9126%, the corresponding ETF would fall 8.7378% to $99.48. The leveraged fund has suddenly fallen below its level on Day 1, despite the S&P 500 not declining below its level of Day 1. Magnify that over a longer period of time and you can imagine what can happen to leveraged funds.
In fact, notice what happens to the leveraged fund in Day 4 and Day 5 if the S&P 500 repeats the same pattern, ending up right where it started. The leveraged fund continues to decline.
3x Leveraged Long ETF
Precisely for the reason that leveraged funds seem to have an affinity for heading toward zero over longer periods of time, you should short a leveraged long fund rather than buy a leveraged short fund when you want to short the broader market. In other words, short SPXL rather than buy SPXS. The triple leverage will work doubly in your favor as the fund declines. This is true not only on a daily basis as the fund declines by three times the amount of the S&P 500, but also over longer periods of time as slippage eats away at the fund's returns. But as I mentioned earlier in the article, the way to short SPXL is by buying deep in-the-money put options. Why is that better than shorting it outright? Let me explain.
First, you want to retain control of your short position. When you own the puts, you are not subject to margin calls, and you can even own them in a cash account. Investors should never underestimate the importance of being in control of their positions.
Second, if you so choose, you can leverage your position without having to trade on margin. For example, if you wanted to short 1,000 shares of SPXL, it would currently cost you about $84,000. For just $150 more, $84,150 ex-commissions, you could purchase 17 of the April 20, 2013 expiring $130 puts for $49.50 each. Those 17 put option contracts would provide you the equivalent of 1,700 shares of short exposure on SPXL. Your cost basis from the exercisable short sale would be $80.50 ($130 minus $49.50) instead of the $84 it would be if you outright shorted SPXL. But once the fund declines by more than $8.50, or 10.12%, you would be better off in the puts than having shorted the fund itself. Here is the math for why that is the case:
Using an $84 cost basis on the outright short position of 1,000 shares, an $8.50 decline takes SPXL to $75.50 and results in an $8,500 profit. At $75.50, the profit on the puts would be no less than $5 ($80.50 exercisable cost basis on 17 contracts). The $5 profit on 17 contracts would result in a gain of $8,500. From that point on, the profit on the puts would exceed the profit on the outright short position as SPXL continues lower.
The reason I say that the profit would be no less than $5 per contract ($8,500) is because as the price of the fund declines, market-wide volatility is likely to increase (as it usually does with a declining S&P 500), thereby pumping up premiums on options. This will add more fire power to the price of your put options. Second, there is likely to be some type of time value built into the bid price of the puts (the price at which you would sell your puts). That should also work to your advantage. Third, even if the market maker attempts to play hard ball and offer you a price on the options that isn't as good as the price at which you could buy back shares in the open market, you can always do the following: purchase shares in the open market, and then immediately call your broker and exercise your puts. That would close out your position. I have had market makers play games with long put positions I've had at relatively illiquid strike prices. When that occurs, I've resorted to purchasing the shares and exercising the puts rather than entering a "Sell-to-close" order in the options market. It is not the preferable way of doing things, but it is a method that ensures you cannot get a completely raw deal when closing your position. If you have conviction in your short thesis and only need a 10.12% decline in a triple leveraged long ETF to make deep in-the-money puts a better deal than outright shorting the fund, it is hard to imagine not going with the puts.
As a brief review, let's recap the reasons for favoring SPXL and specifically deep in-the-money puts on SPXL as the best way to short the market, rather than using funds such as SPXS and SDS, or even opening short positions on SPY or IWM.
1. Triple leverage and slippage will work in your favor, both over the short-term and long-term.
2. The ability to leverage your short position without using margin.
3. Maintaining control over the position by not affording your broker the opportunity to call the short position.
4. Declining markets typically have rising volatility levels. And rising volatility levels pump up option premiums. By owning options, rising premiums will benefit you.
In case those four reasons aren't enough to convince you of the merits of using SPXL and its deep in-the-money options as the favored way of shorting the market, I have three more to share.
The first is relatively simple. By using put options, rather than shorting a fund like SPY, for example, you avoid having to pay a dividend (as short sellers do) and the tax consequences associated therewith.
Second, the delta associated with in-the-money put options works to your advantage should you end up wrong in your convictions. Even investors who are quite confident they will make money on a position should recognize the risk of being wrong. Delta compares the change in price of the underlying asset (SPXL, in this case) to the change in price of the derivative (the deep in-the-money put options, in this case). A delta of 0.5 or -0.5 means that for every $1 move in the price of the underlying security, your derivative (option contract) will move $0.50. When shorting a security outright, you can think of your delta as being negative one. For every $1 rise in the price of the security, you will lose $1. Deep in-the-money put options, on the other hand, have high negative deltas, although not necessarily a delta of negative one. For every $1 increase in the price of the underlying security, those put options will decline by a certain amount determined by the negative delta associated with each strike price.
The advantage of owning deep in-the-money put options is that should SPXL rise in price (meaning you were wrong about the market falling), the delta on the options will work in your favor. For example, the delta might go from -0.9 to -0.7 and then to -0.5 as the price of SPXL gets closer to your strike price. The advantage you have over the outright short seller is that as SPXL goes up in price, you will lose an ever smaller amount on the options per dollar increase in SPXL. It is true that time value will work against you as time goes on (any time value premium built into the option will go to zero by expiration day). But as long as there is time remaining to expiration, SPXL could even climb above the previously mentioned $130 strike price, and the options will retain some value.
Finally, you might find it advantageous to short the market using deep in-the-money puts on SPXL because of the fact that pretty much nobody else is doing it. How do I know this? All you have to do is look at the open interest on the option chain for SPXL. The deep in-the-money puts have anemic open interest. To some, that may be a red flag. For others, it will look like an opportunity. This is especially true for some of the smaller hedge funds looking to short the market. It gives them a way to differentiate themselves both from a creativity perspective (clients might like that they are offering something others haven't thought of) and from a returns perspective.
If buying deep in-the-money puts on SPXL is a strategy that interests you, don't be the last one to the party. The depth of the market for SPXL's put options does not yet appear large enough to sustain a decent influx of buy orders without pumping up the premiums on the options. And buying put options after premiums have spiked is something that no short seller enjoys.