Getting shorty
12/14/18

●Uptrends and downtrends tend to have different characteristics

●Even large down moves can be brief

●Short squeezes occur even in extended bear markets


 

With a true two-sided stock market in force over the past couple of months—shorter-term rallies exchanging punches with downswings—some traders have likely engaged in more short selling, or at least thought about it.

When the market isn’t automatically rewarding bulls with an entrenched uptrend that faithfully rebounds after pullbacks (remember the second half of 2017?), short-selling can offer the opportunity to take profits out of stingy market. But that doesn’t mean traders can simply turn their long-side trading approach on its head.

It’s probably natural to think of downtrends and bear markets simply as inverted uptrends and bull markets, but in reality they’re quite different.

Here’s a basic thought to keep in mind when considering the short side of the market: Good short-sellers tend to be like good party guests—they don’t overstay their welcome.

That’s because downtrends and bear markets tend to take much less time to complete than bull moves—and that can make it challenging for traders to capture profits before the market flips against them.

The past 14 months provide a couple of typical examples. The S&P 500 (SPX) chart below shows two market advances and corrections. The first is the October 3, 2017–January 26 up move and the subsequent drop to the February 9 low. Both moves covered approximately 340 S&P points, low to high. But while the advance took 80 days to complete, the selloff covered the same distance in just 11 days.

S&P 500 (SPX), 10/4/17–11/12/18. S&P 500 (SPX) daily price chart. Slow ride up, express elevator down.

Source: Power E*TRADE


During the advance, the average up day was 0.38% while the average down day was -0.21%. During the 11-day selloff that put the SPX in correction territory, the average up day was +1.12% but the average down day was a whopping -1.76%.

The May 3–October 3 advance was almost a replay: The SPX again rallied around 340 points, this time over the course of 107 days. Then it gave the entire gain back in just 19 days (as of the October 29 low).

These aren’t isolated examples. Even during extended bear markets and high-momentum downtrends and (e.g., 2000–2003 and 2008–2009), short-side profits can be difficult to capture because the most sizable downswings are often sharp and brief, and occasionally interrupted by violent rallies—the dreaded “short squeeze.” Consider this: In 2008—the US stock market’s worst year since the 1930s—the price action wasn’t straight downhill: The SPX had the same number of up days as down days (126), and there were multiple 10% or larger rebounds, including a three-day, 24.35% surge in October.

The reason buy-and-hold has rewarded patient investors over the long-term is that the market has a historical upside bias—and even the worst crashes, bear markets, and downtrends have eventually given way to rallies. Trading, and especially short trading, is a different animal. Smart traders can take steps, such as using stop-loss orders, hedging with options, or decreasing position size, to limit their risk to avoid getting caught short at the wrong moment.

Experienced traders know to take what the market gives them—and be a good party guest.

Today’s numbers (all times ET): Retail Sales 8:30 AM ET, Industrial Production 9:15 AM ET, Business Inventories 10:00 AM ET

 

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