In this article I compare the profit potential from short selling stocks and buying stocks. I do this by testing a strategy that trades various stocks at random and then holds them for different periods.
Can you make money short selling stocks?
Recently, a student of my HTBWS course, asked if I would reveal some profitable strategies for shorting stocks. My answer, somewhat unfortunately, was that strategies for short selling stocks are notoriously difficult to build and implement. There are several reasons for this.
First, stocks have a long-term upward bias. They are real businesses after all and betting on a stock to decline is like swimming against the tide.
Second, there are many logistical difficulties that you get when you short a stock that you don’t get when you buy a stock. There are rules to prevent naked short selling, rules to prevent excessive shorting (uptick rule) and there are rules that protect stocks under a certain price level. As a result, modelling a strategy that trades shorts is much more difficult than for longs.
Third, there is the simple fact that when you short a stock, the potential for profit is capped at 100% but the potential for loss is infinite. In other words, if a $10 stock drops to zero you will have made 100% on your investment, but if it soars to $200, you’re looking at a 1900% loss.
Time to give up on shorting stocks?
Despite the difficulties, it should be noted that the case for shorting stocks is not all lost. According to US Census data, 51.2% of small businesses fail within five years, and although short selling strategies may be hard to model, there are numerous investors who have made money from short selling bad businesses over the years.
As well as this, anyone with any experience in trading will know that stocks seem to drop a lot faster and sharper than they ever do rise. Indeed, in his latest book, Quantitative Technical Analysis, Howard Bandy shows that shorting can actually be safer than going long.
I have not found this to be the case as yet but I do notice that adding a short component to a long-only strategy (even if it is barely profitable) can help smooth the drawdown and improve the strategy overall.
Testing profit potential from shorting stocks
In order to analyse the profit potential from short selling stocks I decided to open up Amibroker and spend some time back-testing various rudimentary strategies. As expected, I did not have a great deal of success. Even with commissions turned off, it was difficult to find a strategy that was able to capture decent sized returns.
I then started looking at entering short positions at random, with different exits. By trading at random we can analyse the potential for exiting with a profit. Might a profit target help performance? What about a trailing stop or a fixed stop? If so, which parameters work the best?
In order to analyse this more closely I set up a simple portfolio strategy in Amibroker. The system shorts 10 stocks at random and holds those stocks until either the profit target or the fixed stop loss is hit. As soon as the trade is close, a new short position is entered in it’s place. The portfolio can hold 10 short positions at one time. As well, the following settings were made:
• Open > $2.
• Volume > 10000.
• Universe is S&P 500 with historical constituents.
• Period is 1/1/2000 – 1/1/2015.
• Commissions & slippage = none.
I then optimised every combination of profit target and fixed stop between 1 and 25. (All stops were entered at the trade price).
As you can see from the table, there was no combination that resulted in a profitable run. For example, when the fixed stop was 5% and the profit target was 10%, the compounded annual return for the strategy was -11.2%. The best result came with a profit target of 9% and a fixed stop of 22%. In other words, stocks were sold and replaced whenever they made 9% profit OR fell 22% in value.
If we now compare this with a long-only strategy (using exactly the same settings) you can see the inherent difference between trading long and trading short. Whereas every run was unprofitable on the short-only strategy, the long-only strategy was nearly always profitable:
Of course, slippage and commissions have not yet been applied so these results are strongly theoretical at this point.
What does all this mean?
It should be noted that the analysis presented here is by no means intended to be an authoritative answer on whether you can make money from shorting stocks. Rather, I was conducting my own research into the matter and decided that this would be useful information to share.
From looking at the data, it’s quite clear that exiting by either a profit target or fixed stop loss is not very effective when short selling stocks. When entering short positions at random, there was no combination of exit than resulted in a profitable run. And this is before the impact of commissions and slippage.
Comparing this with the same test but long-only, we can see that trading on the long side is much easier.
Although the data is not positive for short sellers, traders should not necessarily give up on their quest.
Rather, traders looking for strategies to short stocks need to get creative in their search. They should consider more restrictive criteria for entry and look at market filters, for example limiting short positions to periods only when the broader market is in decline. i.e. only trade short if the S&P 500 is in a bear market.
As well, they should look to combine mechanical methods with discretion; by looking at fundamentals, sentiment, volume etc. In later articles I will attempt to find more successful strategies for short selling stocks.
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