Shorts are Not Just for Summer

With global equity markets adding $1.5T in value and cracking to a brand new all-time high last week, I figured it was the perfect time to discuss short selling.

There are very few areas of life where the ability to “go both ways” isn’t a marked advantage. In basketball, the player who can dribble only with his dominant hand is a far weaker player, and much easier to defend, than the one who can dribble well with both hands. The baseball player who can switch hit is much harder for a pitcher to game plan against and is more valuable to his team because of his flexibility. Even Zoolander’s career didn’t break out to new heights until he figured out how to go right as well as left.

In financial markets, everyone can “go left” and invest on the long side. But far fewer investors are able to make the leap to being a capable and competent short seller. Being able to “go right” gives you a marked advantage over most market participants, who can only go left.

 

Why Short?

The most important reason to short sell is that it can dramatically improve the overall risk profile of your portfolio. I’m not going to get into a discussion of standard deviation, beta and the like. But suffice it to say that having a process that includes adding short trades, with favorable reward-to-risk parameters, alongside your long positions generally results in better risk-adjusted performance.

Here's a quick example of how this improved risk-adjusted performance works.

Throughout this year, I’ve discussed how my U.S. High Growth Index is outperforming the U.S. Slow Growth Index at every turn. Year-to-date, the U.S. High Growth Index has gained 15.1% versus an 8.3% gain for the U.S. Slow Growth Index.

If you are a long-only investor, who can only go left, and have invested in the High Growth Index, you’ve had a solid year, but you’ve been fully exposed to the ups and downs of equity market risk the whole way. But if you were a competent short seller, you could have shorted the Slow Growth Index against your long High Growth Index position. The result would have been a gain of 6.8% (15.1% gain on the long position minus 8.3% loss on the short position), and your risk profile would have been dramatically improved, with month-to-month volatility a whopping 70% less!

Yes, I realize that 6.8% is a lot less than 15.1%, but the risk-adjusted quality of that lower return is far superior to the quality of the higher return. It’s a much safer ride.

Before you fill my inbox with nasty grams about the record low volatility we’ve experienced this year, let me remind you that hindsight is 20/20. Back in December, no one was predicting a period of the lowest volatility in over 30 years.

Most investors would be delighted to take a 7% return just half way through a calendar year. Not to mention that when this low volatility period ends—and it will end—having short positions in your portfolio will likely produce even better risk-adjusted returns.

The value of high quality returns generated by being risk conscious, rather than riding market beta, is easy to overlook when markets are ripping higher and closing at brand new all-time highs each week. Let me be clear: no matter what type of volatility we are experiencing, you should always strive for exceptional risk-adjusted returns.

 

New Opportunities

Another reason it’s advantageous to develop your skills as a short seller is that it opens a whole new category of opportunities. I’m sure you’ve heard the saying “there is always a bull market somewhere.” Well, the same statement can be made for bear markets.

This assertion is easily proven by running through six-month charts of an array of stocks and markets. A portion of those charts will be moving up and to the right, bull market-style, and another portion will be moving down and to the right in a bear market fashion.

While writing this commentary, I quickly ran through a list of a couple hundred markets, and about 35% of them are bearish right now. Being a short seller means that 70 markets are in play for me that are being completely ignored by the “left only” crowd.

Having more markets in play expands my opportunity set, and this expansion could lead to more profit and a potentially better risk profile for my portfolio.

 

To Infinity and Beyond

Short selling gets a bad rap, and I hardly ever see an article, blog post or the like on the benefits and virtues of short selling. It’s time to channel my inner Myth Buster to balance out the short selling picture a bit.

For the record, this discussion is about short selling highly liquid markets and stocks. If you instead choose to short penny stocks that trade 1K shares a day, First Trust ETFs that have $100K in total assets, or accounts receivables for Japanese soy bean farmers, then all bets are off.

Also, because all markets trend higher over time, shorting and holding is a fool’s errand. Never forget that short selling is a tactical maneuver. It requires you to keep your head on a swivel and your finger on the trigger.

A common myth of short selling is that the risk-reward profile of a long trade is more favorable than that of a short trade. That’s because in a long trade, you risk only the amount you purchased, because a stock can’t fall further than $0 and you have unlimited upside potential.

The opposite is said to be true for a short seller: the risk is unlimited and the profit potential is fixed because, once again, a stock can’t go lower than $0.

I’m not going to challenge the fact that a stock can’t go lower than $0; I’m all good with that part of the equation. However, I take issue with the concept that a long trade has unlimited upside potential and a short trade has unlimited risk.

Have you ever seen a stock trade to infinity? Certainly, trades can rally significantly in a short period of time, but never to infinity. Not only that, but I’ve seen just as many trades take the window on the way down as I’ve seen rally swiftly. Whether you are long or short, you always run the risk that company-specific or macro news will cause a trade to move against you quickly and without warning.

 

The Bottom Line

This is far from an exhaustive how-to guide to short selling. Rather, it’s meant as a launching point to further explore how you might implement short selling in your own investment process. In my humble opinion, employing short selling is a critical component of remaining both process driven and risk conscious.