The Benefits of Shorting

Up by the stairs…down by the elevator.

If you’ve been trading for a while, then chances are you know this saying.

Variations of the phrase have been around for decades. It vividly describes a key difference between bull and bear markets. I remember hearing this for the first time in the early 1990s.

The meaning is simple: A bull market takes time. It often feels like a slow slog up the stairs of a 10-story building. Many traders refer to this as climbing the ‘wall of worry’.

Bear markets, on the other hand, are swifter. Forget about a grinding advance. The trip down can often feel like an express elevator to the basement.

So why is this?

Well, much of it comes down to our mental wiring. While people often tread cautiously during the bullish phase, they tend to quickly take flight when conditions change.

Check this out:

Money Morning chart 7-12-18

Source: First Trust Advisors

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I saw this fascinating graphic during the week. It’s from First Trust Advisors — an American investment manager. And it shows the S&P 500 from 1926 to September 2018.

Let me explain what they’ve done…

The graph tracks the market’s performance through eight bull/bear cycles. It also shows the current advance that began in 2009.

Now, a bearish phase occurs when the market falls by more than 20%. These are the red areas on the chart. You’ll also see the duration of the decline, as well as the total and annualised loss.

The average length of a bear market is 1.4 years. This compares to the average bullish phase which lasts for nearly a decade — the bear really does move faster.

Then there’s the respective gains and losses…

The average bear market has seen the S&P 500 fall by 40.6%. That’s a big loss. But it includes an 83.4% wipe-out during the Great Depression. Excluding this period, the average loss is 34.5%.

On the bullish side, the average gain is 479.8%. That’s 11.8 more than the average decline.

This historical snapshot shows why it pays to be long on stocks. Short selling can potentially play a role within a portfolio. But historically, most of the returns are from owning stocks.

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The short list

This is part two of Quant Trader’s performance update. Last week was all about the system’s long portfolio. This week I’ll bring you up to date on the short trades.

Before I start, here’s the chart you saw last week:

Money Morning chart 7-12-18

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This shows the performance of every long position since Quant Trader went live. It assumes placing $1,000 on each signal. And it doesn’t consider costs or dividends.

Quant Trader has made its gains during a choppy and volatile period. The All Ordinaries is only ahead by 9%, or 2.2% per year since the service began in 2014.

Buying into strength, running winners and cutting losses has been a successful strategy. 

But Quant Trader’s short trades haven’t been as profitable.

Here’s their performance chart:

Money Morning chart 7-12-18

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The chart shows the performance of every short signal since 17 November 2014. It assumes placing $1,000 in each trade. No allowance is made for costs.

This is a very different chart to the one for long trades. Looking at this, you’d wonder why anyone would want to trade short. I’ll talk more about this in a moment.

First, here are the stats:

Money Morning chart 7-12-18

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This covers Quant Trader’s first four years — 17 November 2014 to 16 November 2018. It includes open and closed trades to give you the full picture.

The system is making 93 cents for every dollar lost. This equates to a small overall loss. And that’s not unusual. A short portfolio typically makes most of its money during big bear markets.

Shorting is a bit like insurance. Its job is to buffer the long portfolio in a large downturn. The rest of the time I’m happy if it breaks even. Most of Quant Trader’s profits are from long trades.

Now let me show you some of the stocks behind the data.

First up are the best 20 shorts:

Money Morning chart 7-12-18

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Let’s begin by looking at the profit column. Start at the bottom and work upwards.

You’ll notice there’s a steady rise in profits — just like the long trades from last week. This is what I want to see. It shows there’s more than one or two trades contributing to the result.

The average profit is 74.7%. By comparison, the top 20 long trades average 201.8%. Short trades don’t have the same profit potential. That’s because a stock can’t fall by more than 100%.

Now here are the worst 20 trades:

Money Morning chart 7-12-18

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Quant Trader uses a wider stop-loss for short trades. The reason is to maximise time spent in stocks that have been weak. These stocks often fall the most in a big market downturn.

But there’s a cost to this strategy — losses for shorts are typically greater than long trades. The average loss for the worst 20 shorts is 50.4%.

If you trade short, make sure you have a selection of trades. An even spread of risk across many trades is a key part of the strategy.

Knowing why to short

As I said earlier, Quant Trader’s best performing signals are on the buy side. With this being the case, you may be wondering why bother going short at all.

The key benefit of short selling is that it can smooth fluctuations in your portfolio.

Bear markets are a fact of life, we know they happen. If you only have long positions — stocks that you own — then it’s highly likely your portfolio will fall in value.

This is where shorts come in…

Shorting allows you to potentially profit from falling prices. Think of it a bit like insurance. While the stocks you own are generally falling, your short positions might be making money.

Shorting could result in your portfolio losing less money in a bear market. It’s even possible to come out of a bearish period ahead.

I’ll show you what I mean:

Money Morning chart 7-12-18

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This is the All Ordinaries during Quant Trader’s first 15 months. It covers the period from 17 November 2014 to 15 February 2016. It was a pretty tough time for most trades.

Now here’s the performance chart for Quant Trader’s short trades:

Money Morning chart 7-12-18

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As before, this assumes $1,000 on every short signal. There’s also no allowance for costs.

Now, have another look at the chart for the All Ordinaries. The market fell by nearly 20% over the nine months from April 2015. This is when short trades were making money.

A long-only portfolio would likely lose money in that environment. But Quant Trader’s portfolio had the benefit of short positions. This offset some of the losses from long trades.

Quant Traders short trades have since given back these gains. And that’s OK. The purpose was to cushion the overall portfolio when the market was falling.

Shorts will typically be a drag on performance in a rising or flat market. Think of this as an insurance premium — it’s the cost for having some cover when the market turns lower.

So, is shorting for everyone?

Absolutely not.

Shorting carries extra risk. It also takes time to manage. The strategy typically delivers the most benefit in a big bear market. You shouldn’t expect much from it at other times.

Don’t feel you need to act on the short signals. They are there if you want them. But it’s perfectly OK if you prefer to only buy shares. In fact, avoiding shorts can often be more profitable.

Even if you’re not into shorting, you could still benefit from short signals. Simply knowing that a stock’s trend is down could help you avoid some of the worst performers.

Until next week,

Jason McIntosh,
Editor, Quant Trader

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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