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10 myths about short selling

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Steven Spielberg’s movie Jaws has changed forever the way we perceive sharks. Did you know that deep in the comfort of your house lies  something 150 times deadlier than any great white shark ? The probability of dying falling out of bed is 1 in 2 million.  The probability of dying as a result of an exploratory shark bite is 1 in 300 million. Fortunately, we are not on the menu; sharks apparently don’t like junk food.
Like sharks, short sellers are fragile and misunderstood creatures. They are not the nefarious speculators. We are your pension’s best friend
[This is one of the chapters of the upcoming book: “the wisdom of short sellers”. We value your comments and feedback. So, please, help us helping You]

Myth 1: short sellers destroy your pensionbest-friends-forever-glitter-for-myspace

Would it be fair to say that people who hurt your pension should to be fired ?
According to www.Spiva.com, around three quarters of active managers trail their benchmark year after year. Your pension account is therefore better off with passive funds rather than expensive active managers. In bear markets, active managers might claim they outperform their benchmark, when the reality is they still lose money.
Your pension account does not need short sellers in bull markets. During bear or volatile markets, short sellers do make money. Counter-cyclicality is in the job description. So, all your pension account need is an allocation algorithm (see chapter on asset allocation by trading edge) to deploy between passive long funds and active short sellers.
Conclusion: Who is your friend ?
  1. Long Only active managers who have a sustained long term track record of hurting your pension
  2. Short sellers who will make money when the going gets rough.

Isn’t it fair to say that short sellers should be your pension’s new BFF ?

Myth 2: Short sellers destroy companies

The wisdom of short sellers is rarely welcome at executive boardrooms. As a result, they cannot bring healthy balance to the Dunning Dunning-KrugerKruger (*) dark side of the force. Senior managements at companies like Apple (round 1), Lehman Brothers, Kodak, Enron, GM,  Volkswagen are perfectly arrogant, incompetent and stubborn enough to run their venerable institutions into the ground themselves. Short sellers do not compound sub-optimal executive decisions, otherwise referred to as stupid mistakes. They see something going down  and just hop on for the ride.
 (*) Dunning Kruger effect is a cognitive bias in which people are so incompetent that they actually believe they are talented. This affliction is quite prevalent with senior management operates at such altitudes in the layer cake that they incorrectly believe it does not have to stink any more. This is reinforced by an obedient bozocracy,  bureaucrats whose sole “raison-d’etre” is to vigorously acquiesce.

Myth 3: Short sellers manipulate markets

Back in the days, a celebrity hedge fund titan used to publicly announce his investments in Japan. During the ensuing rally, retail flow remained strangely net seller, despite all the hype on investment blogs and chat rooms. Moreover, after-hours dark pool activity showed big blocks were exchanged. Someone was going through great length to discreetly unload a big position…
Had this manager done the exact same thing with a short instead of a long position, he might have attracted a different kind of attention. The public and the regulator do not take it kindly when someone publicly short sells across the nation pension funds large holdings. If You are a short seller, You will be audited. So, it is in your own self preservation best interest to strictly abide by the Law at all times.
If your business model revolves around putting on big short positions and then talk your book, then stop reading this, go buy some coffee mugs and lots of cheap coffee, because “los Federales” are on their way.

Myth 4: Short sellers want the demise of the economy

As we will see in this book, short Selling is a relative game. It comes down to selling the stocks that trail the index and buying the ones that outperform it. There is nothing nefarious about this type of arbitrage.
When market participants turn a bit more risk adverse, speculative stocks tend to come down harder and faster than the boring ones. Your average pension fund manager certainly had initial healthy professional skepticism as to the long term prospects of www.pet_cemetery_in_outer_space.com internet start-up or www.cash_crematorium_diagnotics.com biotech venture. Yet, he just felt pressured into buying, because everyone else did and he did not want to be left out trailing the index. This would cost him his job. Now, that things have hit a bit of a “soft patch”, he is left scrambling to liquidate this toxic nonsense. It is unfortunate that pension accounts end up littered with hollow buzz stocks, but again, short sellers are not responsible for other managers suboptimal investment decisions. They just short-sell underperformers.
 

Myth 5: Short sellers destroy value

Short sellers do not destroy any more value than shareholders create any. If You buy a house, a car, a pen today for 100 and resell it tomorrow for 105 without having done anything to improve it, You have not created any value. You have just made a profit of 5. This comes from a confusion between market capitalisation, value and valuation. The press likes to associate market capitalisation going up or down with value creation or destruction. Warren Buffet said: “price is what You pay, value is what You get”

Myth 6: short sellers are responsible for the collapse of share price

Short sellers need to borrow stocks in order to take short positions. Borrow availability is usually between 5 and 10% of the free float, or shares publicly traded. This represents between on and two weeks of trading volume. Short sellers do not have the fire power to durably affect share price.
Short sellers and big mutual funds have access to the same information. Share prices collapse as result of Long-Only heavy artillery selling, not small time short selling BB gun.

Myth 7: Short sellers accentuate market volatility

Some jurisdictions ban short selling. As a result, buyers can only purchase from a long seller. Sellers can only sell to Long buyers. This widens the bid/ask spread, which increases daily realised volatility. Market participants sell short for different reasons. It is often a way to hedge other transactions such as options, convertible bonds, preferred stocks, baskets etc. Inability to sell short reduces liquidity, increases volatility and ultimately penalizes all market participants. Banning short selling is often a sign of immaturity.
 

Myth 8: short selling increases risk

In theory, unsuccessful shorts can rally multiple times but only drop by 100%. Short-selling is risky, no doubt.
Yet, adding a short book to a long one reduces correlation to the index. It reduces portfolio volatility. The ability to sell short enables alpha generation not only in up but in sideways and down markets.
Think of it as boxing. If You stepped into the ring with Mike Tyson, and chose to punch only with your right hand, what was a tough fight to start with, will be a brief one too.

Myth 9: I don’t need to sell short during bull markets. I will just put on some shorts when the market turns bearish

Short selling is a muscle. It atrophies when not exercised. It is safer to learn the craft during bull markets when the long side can sponsor the tuition. Waiting for the bear market to show up is too little too late. It takes time, effort and money to master the skill, especially the mental side of short selling. Meanwhile, investors are notoriously impatient during bear markets. “the best time to repair the roof is when the sun is shining”, JFK

Myth 10: Short selling has infinite downside potential

If short sellers allow their positions to go up against them multiple times, then they deserve to be un-apologetically weeded out. Short-sellers is an extreme market sport. Joe Campbell got famous after breaking the three basic rules of short selling:
  1. always place a stop-loss: if You don’t have an exit plan, then You will not like what the market has in store for You
  2. control risk through position sizing: the most important question about fund management is: would You rather earn less than You could or lose a lot more than You should ?
  3. stay away from crowded shorts like penny stocks: risk is a binary event: either bankruptcy or recovery.

[Comments, feedback are uppermost welcome. This is a collaborative effort]

@Quora: If most people lose in the stock market or gambling, then would I make money by doing the opposite of the average person?

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My answer to If most people lose in the stock market or gambling, then would I make money by doing the opposite of …

Answer by Laurent Bernut:

Statistically speaking, You would be exactly in the same position as the person You go against

There is something called the serenity prayer. Here is a simple adaptation:out_of_balance_-_Google_Search
Allow me to go with the flow when it is in the right direction
Allow me to stand against the crowd when they are running in the wrong direction
Give the wisdom to know which is which

An ethousiastic reader commented on an answer I provided about predictive technical analysis, saying that the win rate of Fibonacci and  iterations of it such as de Mark have a win rate of around 40%. He said I was an idiot (true) but more importantly if it was the case, people would do the opposite and win (false). While I have rarely been accused of being intelligent, probabilities still do not work like that.

There are three types:
Clear wins
Clear miss
Near miss/win

The third category is between 10 to 30%, 10 for simple (elegant) systems, 30 for simplistic (naive) stuff. So, doing just the opposite of what everyone else does will not make You a hero. Sell Apple short because everyone else is buying will achieve one thing only: provide liquidity for other buyers, thank you very much

How to tilt your trading edge

This is an important point for people who develop systematic automated strategies: improving the trading edge comes from reducing false positives, or moving near wins (small losses) into near misses territory (small wins). The compounding effect of tilting the win rate and the average win has dramatic impact on the overall gain expectancy.

For example, in our strategy, we have introduced a lag in the stop loss, called “French Stop Loss”, because it is fashionably late “bien sur”. This gives additional wiggle rooms to each trade. They can mature and are rarely stopped out. Not all of them succeed however. Some are closed because trend reverts. This is far less costly than stop loss though as trend reversals occur around break even. The number of stop losses has come down by almost 3/4 and now trades are closed around the break even point. This has considerably reduced erosion and has allowed us to increase the number of pairs traded from 12 to 36.

If most people lose in the stock market or gambling, then would I make money by doing the opposite of the average person?

@Quora: How do i improve the sharpe ratio of my trading strategy?

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My answer to How do i improve the sharpe ratio of my trading strategy?

Answer by Laurent Bernut:

Reverse engineering Sharpe ratio is the trademark of some very large shops, with a large pension fund clientele… Like diet, it is simple in theory but not easy in practice.

How to boost Your Sharpe

The basic idea is to generate consistent returns however puny and then magnify them through leverage. Here is how it is done step by step:

  1. Collapse volatility: only one way to do it, collapse net exposure (Long -Short market value) to a band +/-10%. That is tantamount to market neutral. Few strategies can achieve this.
    1. The most common way is pairs-trading. This has built-in market neutrality, but some unpleasant side effects such underwhelming returns and left tail risk
    2. Another way to achieve low net exposure is to run series not on absolute but prices relative to the benchmark. The long book outperforms while the short book underperforms. It then becomes a matter of controlling net exposure. This reduces the correlation risk
  2. Generate low volatility consistent returns: returns can be nanoscopic, it does not matter, as long as they are positive. Consistency matters more than quantity because the denominator is a function of volatility of returns , i-e consistency
  3. Leverage up: if your net exposure is +/-10% and your returns are consistently positive, then You happen to have a low 54d10607d7130_-_pufferfish-bdb80n-deapparent risk profile. So, your prime broker will be willing to extend your leverage. Now, if you clock +0.20% at 200% gross exposure and your PB accepts to lend 4 times, you could wake up with consistent +0.80% per month. times 12 and before You know You will be on the cover of magazines

Limitations:

  1. Very important: Read this Sharpe ratio: the right mathematical answer to the wrong question by Laurent Bernut on Posts
  2. Pairs trading has a nasty side-effect that few people are aware of. It is essentially a mean reverting strategy. It works very well until it blows-up. It does not need to blow up “a la LTCM”. It takes a loss of 3-4% in one month and a full year to recover
  3. Most market participants do not understand Sharpe ratio. They assimilate volatility and risk. Volatility is an expression of uncertainty. Risky strategies are not necessarily volatile, they have open ended risk like short Gamma strategies

Conclusion

Sharpe ratio is part of the Modern portfolio theory package. This dates back to one of the major crimes against humanity of the otherwise barbaric XXth century: the year the US army drafted Elvis. Doctors prescribed pregnant  to smoke cigarettes to calm anxiety back then… Maybe it is time we upgraded our repertoire

How do i improve the sharpe ratio of my trading strategy?