Despite making some solid recovery progress from last year’s volatility, some investors still believe a stock market crash is on the horizon. And among the list of bears includes none other than ‘The Big Short’ investor Michael Burry.
Burry rose to fame after successfully predicting the 2008 financial crisis, placing a massive bet against the markets and eventually pocketing an enormous return. Now it seems he’s found his new biggest bearish play after it was revealed last month he’s placed a $1.6bn bet that the S&P 500 and Nasdaq 100 are headed into the gutter!
As worrying as this may seem, investors may not have much reason to panic. Burry’s move is a little complicated, so let’s break it down and explore what’s happening.
Shorting with put options
In August, Burry’s fund, Scion Asset Management, revealed it’s placed a massive bet against the US stock market using put options.
Without going too far into the weeds, a put option allows an investor to sell stocks at a predetermined price, even if the share price drops below this level. Scion now holds $739m and $886m worth of put options against the Nasdaq 100 and S&P 500 respectively. So if these indices drop, the fund is set to make a fortune.
However, these enormous numbers are a bit misleading. The combined $1.6bn of put options is the market value, not the book value. This means Burry didn’t actually pay this much money to bet against the market. And there’s a good chance he paid significantly less. Let me explain why.
Options aren’t free. Investors have to buy them. And the price of an option is linked to something called implied volatility. This is a bit complicated but, in oversimplified terms, implied volatility can be estimated by a volatility index like the VIX.
Today, the VIX index is trading quite low, meaning implied volatility is also low. As such, put options are cheap. And it’s enabled Burry to place a large bearish bet at a much lower cost than usual. Sadly, we don’t know how much of his fund’s capital is involved with this trade since it’s not disclosed in the regulatory filings. But if he’s right, a small bet can potentially reap massive gains.
When will the stock market crash?
We don’t know Burry’s options’ duration since it’s also not disclosed in the filings. But as an educated guess, I think he expects a downturn within the next nine to 12 months. Near-term bets can backfire spectacularly, making three- and six-month options risky. And long-term options incur time-value costs that can equally decimate his returns.
So if a stock market crash is going to happen, my guess would be at some time in 2024.
As horrific as this sounds, investors should take this news with a massive pinch of salt. Burry’s track record is fairly lacklustre. He’s been calling for a global financial meltdown multiple times since 2017. And those who listened have missed out on tremendous gains, even with all the recent volatility.
Therefore, I think the best attitude to have right now is to keep calm and carry on while ensuring my cash buffer is fully replenished. That way, if the worst does come to pass, I’ll have capital at hand to take advantage of fantastic discounts.
