Sunday, April 13, 2014

Some shorting considerations

In theory, shorting stocks should be a similar process as going long stocks for a trader (and particularly a trend follower) to deal with. After all, a short set up and subsequent downtrend would appear to be the same as a long set up and subsequent uptrend with the chart turned upside down.

However, there are some differences that need to be considered:
  • You many not be able to short the stocks you want;
  • Any rallies within a downtrend can be more violent;
  • Volatility may increase, both in individual stocks, as well as the market as a whole (witness the 13 and 28 October 2008, where the Dow rose over 10% on both days) .
In addition, some traders simply do not feel comfortable with the process of going short. If that is the case, then retreating to cash is the best thing you can do. The danger going forward is avoiding the temptation to try and get into new long positions at the bottom. Those two dates mentioned above did not mark the bottom of the downtrend - the ultimate low at the beginning of March 2009 were an additional 1,500+ points below.

As 2008 was a stark reminder to many, even though the stock market has a historical upward drift, downtrends can persist over a prolonged period of time. Should you use oscillators, oversold readings can remain that way for several months.

Waiting for the indices to start trending upwards, as happened in March/April 2009, was the signal to start looking predominantly at the long side.

In the same way that people have continually called the top of the current market uptrend over the last year or so, when a downtrend occurs there will be people continually trying to call the bottom of the price move. In both cases, trend followers wait for the markets themselves to show them both the direction and the timing of when to start going long or short.

You also have to be wary out other events, well out of your control, which may impact on short positions. As an example, back in 2008, the major UK banks were all in a pronounced downtrend. Then, the Financial Services Authority (as it was then) announced that they banned shorting of certain financial stocks. As you can imagine those stocks affected bounced sharply, triggering trailing stops. Even more frustrating, was the fact that within a couple of weeks, those same stocks were at lower prices than before the ban was put in place. So, governments can also intervene in the markets, either by bailing out companies that are 'too big to fail', or by changing the market environment or rules.

The moral here is that should continue to expect the unexpected. If you go shorting, risk management remains paramount.

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