Tuesday, May 5, 2009

Shorting Stocks: Big Challenge with Little Reward

Most investors who are stock pickers have had the feeling at one time or another that a particular stock would go down. The usual response to this is to sell any shares they have or not buy shares. Some are tempted to short the stock, but this is a difficult game.

Shorting a stock means to sell shares that you don’t own. You are essentially borrowing shares from someone else and selling them with the promise that you’ll buy the shares back later and return them to the original owner. This is done with the hope that the shares will drop in value between selling them and re-buying them so that you’ll make a profit.

Unfortunately for short sellers, stocks tend to go up. Suppose that the stock market tends to go up 10% each year. So, investors in low-cost stock index ETFs make 10% per year, on average, without doing anything. To beat the index as a short seller, you have to find a stock that will go down by about 10% or more.

If a short seller just throws darts at a stock listing, he can expect to lose about 10% each year, on average. If he is so clever that he is able to pick stocks that perform 20% worse than average (so that they drop by 10%), his reward is that his investment returns will roughly match those of the know-nothing index investor.

Short sellers are like runners in a downhill race who choose to run uphill from finish back to start. Taking on added challenges is sometimes admirable, but don’t expect to win any races.

12 comments:

  1. Stocks, on average, have trended higher over time - at least in the past.

    However, over the past decade, that has not been true. I'm not saying that shorting stocks is a great idea (there are better, safer option strategies for getting short), but perhaps it's a new world and the idea that house prices and stock price always trend higher - is over. Who knows?

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  2. Mark: The biggest driver of stock price increases (above inflation) is innovation. As long as humanity continues to invent new things that reduce the need for work and make our lives better, stocks will go up, on average.

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  3. Another solution is to use those single inverse ETF instead of shorting stocks or ETFs. The inverse ETFs are safer than shorting stocks in general. You can only loose what you put in.

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  4. Henry: It's true that inverse ETFs solve the problem of unlimited losses, but they don't solve the problem that stocks tend to go up, and you have to be way above average at picking the right time to buy the inverse ETF just to keep up with those who buy an index and go to sleep for a few decades.

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  5. Short selling is definitely a hard way to make a living. The few who do it successfully, don't simply pick the stocks that they feel will go down (too highly valued, accounting games, whatever). They also actively feed the media with stories. One example that comes to mind is the Enron story by Fortune's Beth McLean was prompted by a short seller. His name escapes me at the moment but he appears in both the book and movie.

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  6. I find the pain of passing over a stock that goes up painful enough. If I were to short a stock and see it go up in a similar way, I would feel twice as bad.

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  7. You know what I think you CAN short and have a good chance of making money? Short sell a leveraged ETF and hold it during volatile markets. It wouldn't matter too much if you chose the bull or bear version either. :)

    It's not as far fetched as you might think...

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  8. Preet: That's interesting. I'll have to think about that one. The lost returns in both the bull and bear leveraged ETFs due to volatility make shorting them a possibility.

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  9. You say that in order to have the same return as a market ETF or index, you would have to pick a stock that goes down by the same amount over the whole year. That involves keeping your short position open for the medium/long term.
    First of all, shorting is much more risky as there is unlimited downside. Obviously as you have stated, stocks trend upwards over time. That means that on average you would lose money every year, as on average the market goes up every year (apart from crashes & recessions of course).
    To make money by shorting stocks, you have to take advantage of the downturns that occur in a much smaller time frame.
    My point is that you should short stock on a day-trading basis (possibly swing trading) to take advantage of the small downturns that occur every odd day.
    That way, you just need to short a stock on the days it goes down (provided you can identify them :)...) and you can beat the 10%/year return any time...This involves quite a bit of knowledge, experience, and balls... I wouldn't recommend it..
    Anyway sorry for the lengthy comment, I just thought this had to be clarified.

    - rogue_trader

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  10. Anonymous: No need to apologize -- I appreciate thoughtful comments, whether long or short. You are right that most short sellers look to make money over short time frames. Curiously, this doesn't change the argument very much. If we take as a starting point that most short sellers have no skill at choosing when to short a stock or index, the expected return over a total of a year's worth of positions is equal to the negative of the expected return on a year-long long position. Of course, the added costs of trading commissions and spreads will be significant if the trader makes many trades, and the day-to-day volatility will swamp the average market movement. Over time, though, the steady upward march of the stock market will work against the talentless short seller as his good and bad luck balance out.

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  11. This post is ridiculous as shorting stocks as a long term investment is obviously a losing strategy. Most short sellers (myself included) use the strategy to hedge our core holdings from market downturns, reducing the overall risk of market declines.

    People who play the market "long only" find the market downturns to be devastating to their long term returns and most have not seen a positive return over the past 10 years. For a good example of strategic short selling, look at the hedge fund industry. Yes, they had a losing year last year as the average hedge fund lost 18.65%. However, if you compare that to the market and average mutual fund that lost 37.6%, this proves that using short selling strategies can reduce risk during market downturns.

    Just look at the facts, from 1987-2008, the average hedge fund is up 14.38% per year*.

    In that same period (1987-2008), the average long only mutual fund is up 7.8%

    Before you talk about short sellers, make sure you really understand the reasons and strategy of short selling.

    Robb Reinhold, head trader for Maverick Trading. www.mavericktrading.com


    *http://www.hennesseegroup.com/indices/returns/hhfiannual.html

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  12. Support: Lacking a reasoned argument often forces people to resort to personal insults. I don't believe your hedge fund numbers. You say that hedge funds lost 18.65% last year, yet the Hennessee Group source of data you cite says that the loss was 22.42%. This source gives returns from 2003 to 2008 that have a compound average gain of 4.9%, but Larry Swedroe (in his April 1 post (no joke)) quotes the HFRX index saying that the average hedge fund return lost 0.7% over those years. I understand the purpose of short selling just fine. A naked short sale is done with the expectation of stocks going down. Some short selling is done in combination with other investments as an arbitrage, and sometimes people choose to hold the same position long and short for tax reasons. All too frequently, though, investors go short out of a deluded sense of confidence in their predictive abilities, and most of these people lose money.

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