Over the last couple of years every time the market pulled back a little it seems the majority of people believe, act, and brace themselves for the next big crash. All you have to do is look at how the $VIX spikes with the littlest of pullbacks. Many immediately want to go out there and short to capitalize in the inevitable decent pullback that at one point we are going to experience. However, shorting is very tough game, a game that has gotten even tougher after 2009, and if one wanted to venture on that side of the field then you should be aware of some rules, stats, and facts.
The biggest rallies happen in corrective/bear markets, exactly when bears should be making a killing. The minute you get over confident that this is the end of the world you get a simple 3-5 days dead cat bounce that wipes you out. If we are truly in a bear market that bounce will fade and lead to lower prices.
Over the last 35 years, the average intra-year decline in the SP500 is roughly 14%, a little less since 2009. Despite the 14% intra-year decline, the SP500 has closed positive 27 out of the 35 years, 77% of the time.
Michael Steinhardt one of the pioneers in the hedge fund industry once said that he probably has shorted more stocks than anyone else and when he looks back cumulatively at all his shorts he probably broke even on them.
Here are some of the rules I have when it comes to shorting;
1. Don’t short oversold markets, the market has a history of bailing out the bulls, not the bears. Currently we are oversold, and you might hear that oversold can become more oversold, but the odds always favor a dead cat bounce than an outright crash.
2. Don’t short an index or a stock that is already down multiple days in a row, indices tend to mean revert. Take a look at this stat chart
of the outcome of the SP500 after 4 consecutive down closes.
3. Every now and then you might get lucky shorting an oversold market that becomes more oversold and stays oversold, but the distance between every now and then is huge. Don’t do it.
4. Do not short a stock that is down multiple days in a row, wait for the bounce (3-5 days) then short preferably with some of the moving averages above the price of the stock.
5. Do not overstay your welcome on the short side, again, the biggest rallies happen in bear corrective markets.
6. Shorting is very enticing due to the fact 6 months worth of gains in a stock could easily be wiped out in a matter of a month, look at the oil names, biotechs, and the SP500 in the last 5 days. However, all the stats are against you so do it selectively and at the right time. In the last 89 years, stocks have closed down 20% or more 6 times, 6.7%. 35 out the 89 years stocks delivered 20%+ returns, 39.3%.
7. Shorting a fundamental story is different than shorting something technically.
8. Shorting the so-called “leaders” that have broken down tends to be very profitable, focus on those. There is a stat that states that 80% of the biggest winners at one point lose 50% of their gains and 50% of them lose 80% of their gains.
The bottom line is that you have to be more selective and diligent with your timing when it comes to shorting versus going long.