What Is Your Thesis for Shorting

Introduction

Lots of new traders are thrilled by the potential in shorting and are particularly interested in shorting assets and markets. Sometimes they simply short for the sake of it. For traders who have a strong short bias, they do enjoy watching the movie "The Big Short" where the market crash was predicted by a group of hedge funds and Michael Burry was admired for being one of the few who made a huge profit in betting against the housing market. At that time, he had a valid thesis for shorting, but not in 2023 when he tweeted "Sell" and the market has been up over 40% since. So here's a question for you, my friend, when you're shorting: What is your thesis?.

Why Do We Short?

Core Reasons:

1. Capitalizing on Overvaluation:

   • When assets or markets deviate significantly from their intrinsic value, short selling captures the opportunity for correction.

2. Navigating Downturns:

   • Provides a mechanism to profit or protect portfolios during bear markets or sector-specific declines.

3. Hedging and Diversification:

   • Allows traders to offset risks in their long portfolios by betting on declines in correlated or overexposed assets.

What to Short?

Short selling isn’t merely about betting against an asset; it’s about crafting a thesis grounded in research, logic, and market dynamics. Whether addressing structural flaws in a market or capitalizing on cyclical downturns, shorting provides traders with tools to profit from or hedge against declines.

Below are the common theses for what traders might want to short:

• Oil:

  • Structural Weaknesses: Global push towards renewable energy threatens oil's long-term demand.
  • Economic Sensitivity: Oil demand is closely tied to economic cycles.
  • Supply and Demand: The US has become the world's biggest producer with the goal of driving down inflation and providing affordable energy.

• Housing Market:

  • Bubble Dynamics: Persistent price increases fueled by speculation, low-interest rates, and loose lending can create unsustainable housing bubbles.
  • Macroeconomic Pressures: Rising interest rates increase mortgage costs, cooling demand and leading to price corrections.
  • Demographic Shifts: Aging populations and changes in work preferences (e.g., remote work reducing demand for urban housing) can alter long-term housing demand.

• Foreign Currencies:

  • Structural Weaknesses: Overvaluations in foreign currencies often signal good shorting opportunities.
  • Macroeconomic Pressures: Overheated economies, excessive inflation, fiscal pressures, and geopolitical tensions can lead to adverse currency conditions.
  • Economic Sensitivity: Foreign currencies are often sensitive to economic shocks and market conditions, making them a suitable asset for shorting.

• Cryptocurrencies:

  • Pump and Dump: Artificially inflated prices, psychological manipulation to trigger FOMO.
  • Sentiment Analysis: High levels of hype or overly optimistic projections often precede downturns.

• Stocks:

  • Financial Fundamentals: Overvalued, over-leveraged, weak earnings growth, high leverage, and unsustainable valuations often signal good shorting opportunities.
  • Market Dynamics: Rapid shifts in investor sentiment make stocks prone to price spikes, often defying fundamental analysis.
  • Sentiment Analysis: High levels of hype or overly optimistic projections often precede downturns.

• Overhyped Pharmaceuticals:

  • Research Fundamentals: Highly touted, unproven therapies, likely-to-fail or failed clinical trials, unrealistic expectations of future clinical trials, fraudulent marketing, and lack of transparency.

• Markets / Companies Impacted by Negative Economic Events / News:

  • Panic Selling: Market panic with strong fears of recession or market crash.
  • Market Downturn: Economic downturns, geopolitical tensions, or geopolitical tensions.
  • Market Sentiment: Scandalous events, unhappy investors, damaged reputations, or negative media coverage.
  • Regulatory Changes: Regulatory changes, tax changes, or changes in government policies.

Specific Cases:

Shorting Oil

1. Structural Weaknesses:

   • Global push towards renewable energy threatens oil's long-term demand.
   • Increasing regulatory scrutiny, carbon taxes, and the rise of electric vehicles contribute to systemic pressures on oil markets.

2. Economic Sensitivity:

   • Oil demand is closely tied to economic cycles. A global recession or slowdown in industrial production can significantly reduce consumption.

3. Geopolitical Factors:

   • Oversupply driven by OPEC dynamics or major producers failing to align production cuts with demand trends can create price collapses.
   • Example: The 2020 oil crash when demand plummeted due to COVID-19 lockdowns.

Shorting the Housing Market

1. Bubble Dynamics:

   • Persistent price increases fueled by speculation, low-interest rates, and loose lending can create unsustainable housing bubbles.
   • Examples: The subprime mortgage crisis of 2008 highlighted the fragility of over-leveraged housing markets.

2. Macroeconomic Pressures:

   • Rising interest rates increase mortgage costs, cooling demand and leading to price corrections.
   • Stagnant wage growth further exacerbates affordability issues, shrinking the buyer pool.

3. Demographic Shifts:

   • Aging populations and changes in work preferences (e.g., remote work reducing demand for urban housing) can alter long-term housing demand.

Why Avoid Long-Term Shorting Some Assets

Market always has its ups and downs, and you can always make a profit by shorting an asset when it is in a downturn. Long-term shorting some assets can be a bad idea and you can actually make more profit in going long than shorting. So why shorting? Here are a couple of assets that can be considered in this category:

US Market Indices

1. Economic Growth:

   • For the market such as the US market, there is always strong economic growth with rising GDP and advancement of technologies.

2. Popularity:

   • The S&P 500, Dow Jones, and Nasdaq Composite are among the most popular market indices attracting investors and traders around the world.

Bitcoin

1. Scarcity and Adoption:

   • Bitcoin’s limited supply combined with growing adoption as a store of value and payment system reinforces its long-term strength.

2. Hedge Against Monetary Instability:

   • During periods of high inflation or fiat currency debasement, Bitcoin attracts capital as a decentralized and inflation-resistant asset.

3. Branding and Reputation:

   • Bitcoin is a well-known asset and has created a strong reputation around the global market. People trust it as a safe haven and a store of value.

4. Money Without Borders:

   • Bitcoin is a digital currency that can be used globally, making it a popular choice for international transactions.

Tesla

1. Innovative Growth:

   • Tesla dominates the EV market with a significant technological and branding edge. Its forward-thinking strategy spans beyond vehicles to energy storage and software innovation.

2. Investor Loyalty:

   • Tesla benefits from a fervent retail investor base, making its stock prone to sharp upward moves that can disrupt short positions.

Even given the above theses, it can't be said those assets are not shortable and during the market turmoils and uncertainties, it is up to each individual's trading skills and trading strategies to make the most of it. For examples, although there weren't many times that markets crashed, but when the markets tanked, they tanked hard.

Building a Robust Shorting Thesis

Key Steps for Crafting a Winning Strategy:

1. Understand Macro and Micro Trends:

   • Evaluate the broader economic environment and specific industry trends impacting the asset.

2. Examine Financial Fundamentals:

   • Weak earnings growth, high leverage, and unsustainable valuations often signal good shorting opportunities.

3. Identify Catalysts for Decline:

   • Look for events that could trigger a significant drop, such as earnings misses, regulatory shifts, or external economic shocks.

4. Incorporate Sentiment Analysis:

   • High levels of hype or overly optimistic projections often precede downturns. Use sentiment indicators to gauge market exuberance.

5. Define Exit Strategies:

   • Set clear entry, exit, and stop-loss levels to manage risk effectively.

Shorting Thesis and Shorting Strategy

1. Thesis:

   • Define the specific asset, market, or industry you're shorting.

2. Shorting Strategy:

   • Craft a clear and effective shorting strategy that includes entry, exit, and stop-loss levels.

3. Risk Management:

   • Set clear entry, exit, and stop-loss levels to manage risk effectively.

4. Execution Strategy:

   • Develop a disciplined and consistent execution strategy to reduce risk and optimize profits.

5. Monitoring and Adaptation:

   • Continuously monitor market conditions and adapt your strategy as market dynamics change.

In order to increase your chances of success, it is important to have a clear and well-defined shorting strategy that aligns with your thesis and risk management objectives. Even with a solid thesis, there’s no guarantee the market will move in your favor; success hinges on timing and aligning with the moment when the tides actually turn. For examples, it took two years for the housing market to crash after Michael Burry began buying credit default swaps on subprime mortgages. As the old saying goes, "The market can stay irrational longer than you can stay solvent".

Conclusion

Shorting is as much an art as it is a science. By focusing on assets like oil and housing markets, where structural and cyclical weaknesses are evident, traders can develop a strong thesis for shorting. However, long-term bets against transformative assets like Bitcoin and Tesla often defy logic due to their innovation, strong fundamentals, and unpredictable sentiment.

The key to mastering shorting lies in rigorous analysis, disciplined execution, and the humility to adapt as markets evolve.