The short-selling challenge

07/05/19
  • The stock market spends more time going up than going down
  • Quality short-selling opportunities can be infrequent and short-lived

Whenever there’s talk of a possible economic slowdown, especially after a big run-up in stocks, many traders can feel a familiar urge—to fire up the shorts. Sometimes it’s a good idea, other times not. Either way, there are two market realities potential short traders should keep in mind:

1. There’s a documented long-term upside bias to the stock market.

2. Down swings and bear markets tend to be shorter than up swings and bull markets.

Regarding the first point, between June 20, 1989 and June 20, 2019 the S&P 500 (SPX) had 4,049 up days and 3,505 down days. That’s nearly two more years of “up” than “down” out of 30, and if that doesn’t sound like much, keep in mind it was enough to produce an 820% rally during that period.

When you sell short—at least, when you short stock-index ETFs or futures—you’re effectively fighting that entrenched upside bias. The market can go up more, and for a much longer time, than many people think.

On top of that, traders can’t simply turn bullish principles or strategies on their heads, because when the stock market sells off, it often behaves differently than it does during rallies.

S&P 500 (SPX), 9/26/18–5/15/19. Down faster than up.

Source: Power E*TRADE


For example, it took the S&P 500 (SPX) just 13 months (October 2007–November 2008) to wipe out the preceding five-year rally. More recently, it took the SPX just 57 trading days after October 3, 2018 to shed around 574 points and reach the December 24 low (chart above). But it took the index 84 days to recapture that loss—almost five weeks more—even though the stock market was staging one of its strongest starts to a year in the past six decades. Short selling can also be complicated by sharp rebounds that often occur within even the strongest down moves, as highlighted in the chart.

Individual stocks can be even more extreme. Consider the moonshot Tilray (TLRY) made last year before coming back to earth. The stock, which closed at $22.39 on its first day of trading (July 19), more than quadrupled by September 5:

Tilray (TLRY), 7/19/18–6/25/19. Shorts got squeezed, then longs got crushed.

Source: Power E*TRADE


There were probably more than a few traders who thought the stock’s rally was a little overdone at that point. Those who went short—say, around $90–$100—enjoyed all of a two-day pullback before the stock turned higher again and, over the course of six trading days (September 12–19), more than tripled to $300.

The ultimate irony is that the stock imploded almost as quickly as it skyrocketed. It hasn’t traded above $100 since December, and by June it had fallen around -89% to $34.25. So, those short sellers who thought the stock was overbought when it was around $90–$100 turned out to be right. It’s a good bet that none of them held their positions until this June, though. Unfortunately, as someone once said, the goal is to make money, not to be "right."

The point is not that traders shouldn’t short, just that they need to consider the realities of the market. For experienced, disciplined traders, short-selling can be a way to generate profits when most market players are losing money. But equities are, in the long-term, biased to the upside, which suggests traders would be wise to take quicker profits on short positions than they do on longs, and always cap their risk on trades (i.e., use stop-loss orders) to avoid the dreaded short squeeze.

Today’s numbers (all times ET): Employment Report (8:30 a.m.), EIA Natural Gas Report (10:30 a.m.), Baker-Hughes oil rig count (1 p.m.).

 

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