Don't short a bubble

Bubbles are very tempting to short. Everyone knows that bubbles end with mega-crashes. Everyone knows that there’s a lot of money to be made by shorting these mega-crashes if you get the timing right. Many post-bubble crashes go down more than 80% or 90%.
Shorting bubbles reminds me of the saying “there are old traders and there are bold traders, but there are no old and bold traders”. You might make a lot of money by shorting a bubble. But you will probably first be steamrolled by the bubble if you short it. Here’s why you should never short a bubble.

Shorting is dangerous. Shorting a bubble is even worse.

Shorting a market is much more dangerous than being long a market. Your losses are limited when you trade on the long side. Your losses are unlimited when you trade on the short side. Hence, the assymetry of trading works against shorts. A market can only fall 100% at most, but it can rise 200%, 300%, 400%, etc.
Shorting a bubble is worse because the upwards movements are even more extreme. E.g. if a market normally goes up 1% a day in a healthy bull market, it can go up 4% a day in a bubble. Hence, shorting a normal bull market might result in a 1% loss each day, but shorting a bubble can result in a 4% loss each day.
The magnitude of potential losses from shorting a bubble are higher.

Timing the top is impossible

Your timing must be extremely accurate when you short a market. Bubbles soar at a rapid rate, and even being early by just a few days can lead to double-digit losses on your short position.
Contrary to what some traders will tell you, it is impossible to CONSISTENTLY and accurately time the top in bubbles. Sure, a trader might catch the exact top once or twice. But it’s impossible to consistently catch the exact top.
This is where the saying “markets can be irrational longer than you can be solvent” comes from. Bubbles are by definition irrational. Irrational markets don’t follow any technical pattern that can be used to predict the exact top.
You have no idea how crazy the human imagination can be in a bubble. Speculators literally start to believe that the sky is the limit. Anyone can say “this is a bubble”. But timing the top of that bubble is extremely difficult, and trying to do so is also extremely dangerous.
For example, most people thought that Bitcoin was already “the fastest bubble” in history when it went to $2k a coin. Anyone who shorted Bitcoin at $2k because it was “a bubble” would have been killed. It continued to soar until $20k.

Some traders believe that you can use a “flag” pattern to predict bubbles. According to their thinking, a bubble should soar, consolidate, and then soar again before topping. Here’s the problem: some bubbles have more than 2 uplegs.
Some bubbles soar, consolidate, soar, consolidate, soar, consolidate, and then soar before topping. You have no idea how many uplegs a bubble will have before it ends.

Your position size must be small because you must set aside room for margin.

Traders who short bubbles have to set aside a lot of margin because the market can soar a lot more in the short term. This forces them to shrink their position size, which means that their potential profits are a lot less than what it could be.
You have to set aside room for margin unless you can catch the EXACT top (and nobody can do this). This margin will be a drag on your performance if the market starts to crash. Your position size will be too small!
Some traders try to resolve the margin problem by buying an inverse ETF (inverse ETF’s rise when the market falls). Inverse ETF’s face erosion, which means that these securities lose value over the long run even if the market is flat.

Maybe you’re wrong. Maybe it is a new paradigm.

Conventional trading wisdom laughs at the words “this time is different”. But every now and then something truly is “different”. Otherwise the world would always be stagnant.
Bubbles are “bubbles” in 20-20 hindsight. But “a new paradigm” truly does become a new paradigm every now and then . For example, Amazon was considered to be a “bubble” stock in 2013. It has since continued to soar because Amazon proved itself. Amazon has since continued to grow its business at a rapid pace and proved its business model.
Sometimes reality just needs a bit of time to catch up with bubble-like valuations. The market is no longer “in a bubble” once reality catches up and can justify those previously bubble-like valuations.

Don’t look at a bubble on a linear scale. Look at it on a log scale.

This is a basic mistake that some traders make. Everything looks like a bubble if you use a linear scale in a bull market. A log scale is different. A market is only “in a bubble” if it’s going parabolic on a log scale. A log scale uses percentages.

2 comments add yours

  1. In other words, don’t short Netflix right now. Now to go or not to go long on Netflix, that is the question.

    • Exactly. Even people like Jim Chanos have a tough time in bubbles. And he’s one of the best short-only fund managers out there.

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