Introduction
Buying and selling are the two most basic tools the markets give us, so why is it that we focus so heavily on just one of them? Being long only (buying) is undoubtedly the simpler option — it’s easier to understand, to manage, and it gets the job done over the long term. It works well for those who want a no-stress, passive portfolio.
If you are one of those people, you probably don’t realise how much value you are leaving on the table.
Integrating short selling (profiting from an asset falling in price) into your strategy may help you keep the profits you make during a bull market, once a bear market inevitably comes along. It may also help to lower your overall risk, and you may even be able to turn a positive return while the markets head lower!
Major market cycles
The market moves in cycles, up and down, again and again — and while the major trend is historically up, the down periods are recurring and sometimes significant in their magnitude and duration. Why not account for them, or even make the most of them? We have the necessary tools at our disposal to take full advantage of these periods!
Do you know that if you were invested in the Nasdaq at its peak in 2000, you would have suffered an 84% drawdown and you wouldn’t have broken even again until 2015? Fifteen years!
Past performance is not an indication of future results
This is a dramatic example, but don’t think it’s unique. Big drawdowns and periods of stagnation are a normal part of market cycles.
Since 2009, we have had an epic bull market and have become conditioned to be long only, to buy every dip, because it has quite simply made sense! Many investors have mistakenly become accustomed to using the last decade as their entire sample size, and extrapolating a market that will continue to go up forever. Unfortunately, that’s not quite how markets work.
The surprising maths behind drawdowns
Short selling is not just about trying to make a positive return on the way down, it’s first and foremost about simply not giving too big a portion of your bull market profits back.
You never know how deep the next correction is going to be. Most people don’t realise that the hole they’re digging by stubbornly staying long during a bear market becomes exponentially harder to get out of as it gets deeper.
Example: If you go through a 50% bear market while being fully invested, that’s tough, but you may think: “I can achieve a 50% return in the next few years to get me back to breakeven.” Well, hold on a minute. If you’ve gone from a portfolio worth $1,000 down to $500 and you now get a 50% gain, you’re at $750, you’re not back at $1,000. You’ve lost 50%, but you now need a 100% gain just to get you back to where you started. This calculation shows why it’s so crucial to take action to protect your portfolio from drawdowns. It just gets worse the lower you go (for example, a 75% loss requires a 300% gain to get you back to breakeven).
It’s just as important to protect your capital from drawdowns as it is to focus on growing it, if not more so! If you miss out on some gains, you can always wait for another opportunity, but if you lose all your chips, you can no longer play.
Why not use every tool the market offers you?
Markets are competitive. It’s easy to forget this, as many have been used to generating handsome returns without having to put in much work. While that may be the case over a period of time (mainly bull markets), if you want to produce superior returns consistently, over a longer time frame, you can’t do what everyone else is doing.
This is not an easy feat, and people go to great lengths to gain even a tidy edge. Going long and going short are the two most basic tools the market offers us, so it seems absolutely crazy to not even consider using both of these two main tools.
So…what is shorting, actually?
It’s a term that’s thrown around, often with some negative connotations, and is made to sound very risky, and sometimes even evil! Let’s take a closer look.
Let’s say you think the price of Tesla is going to fall — how can you make a profit from an asset going down? You find someone who is willing to lend you their Tesla shares. You agree to borrow one share of Tesla (currently worth around $600) and to pay a small amount of interest on it until you return it. The key is that you don’t owe the lender $600, you owe them one Tesla share. You immediately sell that Tesla share on the market and hold on to your $600. If the market then moves in your favour and some time later Tesla is trading at $300, you’ll be able to buy one share back for $300, repay your debt of one Tesla share, while still having $300 left over!
Of course all of this happens in the background — all you need to do if you want to short is to click sell! Now that we understand how shorting works, let’s look at how we could use it to build a superior strategy in the markets.
Using a long/short strategy to hedge
Nothing to do with gardening, hedging in this context means trying to minimise your level of risk, by taking positions that are expected to produce a return which is the opposite of your current holdings.
Let’s say you’re holding a TSLA position, which you want to keep for the long term, but you think the stock may be a bit overheated at the moment. What you could do is to short sell an equal dollar amount of an index or ETF which is highly correlated to TSLA, such as ARKK or the NSDQ100. By doing this, if you start to lose money on your TSLA position, you’ll be making a similar amount in profits from your short. On the other hand, if Tesla continues to rise, those gains will be mostly offset by losses from your shorts.
One option is to find an asset that is as similar as possible on the surface (in Tesla’s case, this could be another EV company such as Rivian Automotive), and that is, therefore, perceived to have a very similar risk profile. This way, by being long one and short the other, you can bring your risk down to almost zero, as if one goes up, the other should go up by a similar amount and vice versa. However, if you’re long, the best company in the space (Tesla in my opinion), and short the worst, you’ll be able to turn a profit while being exposed to minimal risk. In this example, you believe Tesla is likely to go up more than Rivian in a bull market (and down less during a bear market), thus, allowing you to make more on your long position than what you’re losing on your short (or vice versa), all while maintaining a close to neutral net exposure.
Strategies are not black and white
While some advocate for a long-only strategy, and others for a long/short strategy, it’s important to remember that we’re talking about a spectrum. You could be 100% long, 100% hedged, or 100% short, but there is also a large middle ground between these positioning extremes. If you feel the market is overheated, or that a particular stock is overvalued, you may want to open some short positions that account for, let’s say, 20% of your portfolio, while remaining 80% long. Or you may be mostly short in the market, but there are individual stocks that you want to keep open as long. There are endless combinations and nuances.
Take the current market as an example — you could be short in the indices as they continue to trend down, while maintaining long positions in commodities or defense & oil stocks. This strategy would have hedged out a lot of your directional risk, while actually producing a positive return on both your long and your short positions! The bottom line is that an optimal strategy is trying to capture the most upside, whatever the market conditions, while being exposed to the smallest amount of risk possible.
Another form of diversification
Try thinking of portfolio directionality in diversification terms. Everyone is familiar with the traditional idea of diversification: don’t put all of your eggs in one basket! This is classic advice as you don’t want to risk everything on one variable. If your whole portfolio is invested in Amazon, but the company starts to perform poorly, your whole portfolio would do poorly. That’s why you would include other assets. If some are not doing well, chances are that at least some of the others will be.
Directional exposure is the same idea: being totally long, which is the most common form of investing, feels incredibly undiversified to me. All of your positions are relying on the same variable (e.g., that the market will continue to be healthy and go up) and are likely to be quite correlated. If the markets take a big hit and you don’t make any changes, you could end up with some very large losses. This becomes increasingly true when the markets take a very big hit — as volatility increases, so do correlations. This is because people panic and start selling everything indiscriminately. In that scenario, having a diversified basket of long positions won’t do you much good — the only diversification that will actually help you is to have some shorts!
Isn’t being short very risky?
Technically speaking, a short position in isolation has a much riskier profile than a long position. There are two main reasons:
- Historically markets trend upwards, so by being short, the odds are against you (over the long term).
- The maximum gain you can make by shorting is 100% (if the asset you’re shorting goes to zero), whereas your maximum loss is unlimited (as an asset can technically continue increasing in price to infinity).
- Short positions are CFD positions. CFDs are complex financial products that can be speculative in nature. CFDs may not be suitable for all investors and you don’t own the underlying assets. You risk losing all of your investment in periods of high market volatility
But wait — it’s not that simple. While there are risks in holding shorts on their own, holding shorts in a balanced portfolio may actually reduce some of your risks. Think about it — when you’re long only, you’re constantly open to the risk that stocks will tumble. No one knows when an ugly bear market could appear, so you’re always exposed to the chance of a significant drawdown. On the other hand, if you have a mix of longs and shorts, you’ll at the very least dampen the hit.
Conclusion
While adding short positions to your portfolio may seem complex or risky, it may be a great way to reduce your overall portfolio risk and protect you from times when markets are trending down.
Including some hedges or outright shorts in a portfolio does take skill, judgement and timing. For those who have a long-term time horizon, and who want to keep investing as simply and passively as possible, it is perfectly acceptable to have a long-only portfolio. But if you’re trying to consistently outperform the markets, during the ups and the downs, you simply have to use a more active strategy that includes short positions too.
Buying and selling are the two main tools with which the market provides us, so using only one of the two is always going to be leaving some value on the table, in my opinion.
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