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The Art of Short-Selling

Over the past couple of weeks, short-sellers have been crushed by a fast and furious market rally. As I’ve noted quite often, the biggest bounces always occur in the worst markets. That is one of the main things that can make short-selling so difficult. Even in the depths of an ugly bear market, an abrupt counter-trend move can destroy well-planned shorts.

The great appeal of short-selling is that it is the best way to produce significant market outperformance in a bear market. Simply not losing money is a good way to deal with a bear market, but the way hedge funds make big money is by producing additional performance via short-selling. Hedge funds typically will underperform in bull markets but will more than make up for it with outperformance in bear markets.

Stocks do not go down in the same manner that they go up.

The primary thing that traders need to know about short-selling is that bear market trading is not simply the inverse of bull market trading. Stocks do not go down in the same manner that they go up. If you use the inverse of bull market tactics in a bear market, then you are going to have a very difficult time.

Stocks tend to correct abruptly. There is an old market saying that stocks take the escalator up and the elevator down. Anyone that has traded through a number of market cycles is aware of how months of hard-won gains can disappear in a matter of days or weeks when a market correction hits.

An Anticipatory Approach

Because of the abruptness of market corrections, good short-selling requires a more anticipatory approach. I often preach that it is better to use a reactive approach to trading, but that applies more to long-side trades and investments that tend to develop over a longer period of time. If you miss the early stages of an uptrend, there is likely plenty of time to still participate. However, if you miss the early stages of a pullback, it is often too late to do much.

Since short-selling requires a more anticipatory approach, it makes sense to build short positions incrementally and be ready to be on the wrong side of the trade for a while. One of the most difficult aspects of short-selling is it can be very grueling to be on the wrong side of the market for an extended period of time. However, when the bulls are the most confident and celebratory, it is generally the time when shorts should start to take action.

Patience often works better for long positions than short positions.

I am not a strong short-seller for a couple of reasons. The first is that the focus is much more on timing. I actively avoid calling tops and bottoms as I try to stay with trending action as long as possible. Short-sellers have to focus much more on predicting turning points because the drops are much more abrupt. Downtrends do not last as long as uptrends. Therefore the time frames for short-selling are usually much shorter. Patience often works better for long positions than short positions because of the market’s long-term upside bias.

The main reason I am not an active short-selling is primarily mindset. I spend the vast majority of my time looking for potential longs. I tend to have more confidence in long-side trades because I can use a combination of technicals and fundamentals to help build positions and manage them. Stocks are mispriced in both directions, but, in my view, the overpricing can be much harder to discern than the underpricing, especially when you consider the emotionality of bulls.

Becoming a Better Short-Seller

The easiest way to become a better short-seller is to cultivate a greater level of skeptical thinking. It has to be a conscious decision, and then once the decision is made, the appropriate tactics for dealing with a short have to be in place.

Another major consideration with short-selling is the time frame. Long-term shorts of individual stocks is an extremely tough game to play. Just ask those that have been trying to short Tesla (TSLA) for years. Even activist shorts that have compelling arguments can be destroyed, as those that went after GameStop (GME) and AMC Entertainment (AMC) found out.

Many aggressive bullish traders actively go after stocks with large short positions in an effort to create short-squeezes. Being on the wrong side of this action can destroy capital faster than anything else.

In bear markets, the selling action is often more correlated. All stocks end up being sold without much regard for their individual merits. In this sort of environment, it can make more sense to use inverse ETFs as a way to play the short side. One of the benefits of these ETFs is that they can be used in retirement accounts or other tax-favored vehicles that normally don’t allow short-selling. If you are interested in learning more about short-selling, it is probably best to start with index ETFs rather than individual stocks.

Investors and traders can navigate the market very well without ever short-selling, but it can greatly enhance returns if done right. Just be aware that short-selling is not just the reverse of going long. It is a very different trading approach.

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