Shorting ETFs - Goodbye To The Old Risks 15 comments
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An excerpt from the new book by David Fry, 'Create Your Own ETF Hedge Fund: A DIY ETF Strategy for Private Wealth Management,' reprinted with permission of the author and publisher:
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Goodbye to Those Old Shorting Risks
Prior to the introduction and proliferation of ETFs, shorting was seen as a high-risk strategy reserved for professionals only. To the average investor, this technique looked like gambling. However, this view was largely based on a fundamental misperception of the level of risk that shorting entails.
A routine question on brokerage qualifying exams used to be: "Is it riskier to be 'long' or 'short' stocks?" The correct answer was Short. Why was that? The reason given was that a stock had an unlimited upside if you were "long," whereas if you were "short" your opportunity was confined between the short price and zero and your risk was unlimited. This answer does make mathematical sense, but it doesn't make common sense. Who on earth would short a stock at, say, $20 and maintain a short position if it went to $100 or more? No one. If the value of the stock you shorted were rising, your broker would have to request more collateral from you. The only way for you to stay in under these circumstances would be to continue advancing more money on the losing short sale. Only a fool would do that.
In the recent bear market, many people rode stocks or corrupt mutual funds from $100 to $20, which was just as foolish as shorting a stock at $20 and riding it to $100. If these investors had known how to use shorting they could have protected themselves from much of this loss.
Of course, shorting individual stocks can be risky. First, you have to be able to borrow a stock on margin. Each brokerage firm carries different margin requirements for each stock, and some stocks are more liquid (more easily borrowed) than others. The "uptick rule," which requires each short transaction to be preceded by an uptick, also makes shorting more difficult to accomplish. Finally, there is the "single stock risk." Good news on an individual stock can be the ruin of most short sellers, while with an index or ETF, good and bad news is spread over many stocks.
Most short sellers over the past two decades have found that the options market has offered more opportunity to prosper from both long and short positions. Options eliminated many of the drawbacks of actually shorting an individual stock, but they introduced even more risks. Option premiums and expirations have become too complex for average investors, and most individuals dealing in options have lost money, and continue to lose.
As ETFs have expanded in scope to include many major global indices and sub-indices, they have eliminated many of the risks associated with earlier shorting techniques. First, there are no borrowing or margin difficulties for most ETFs. Second, for most ETFs, the uptick rule has been eliminated, so selling the QQQQ (Nasdaq 100 ETF) or SPY (S&P 500 ETF) is as simple as saying "long" or "short." And most importantly, shorting an index is less risky than shorting an individual stock.
Even though I believe most stock indices go up over the long term, there are serious bear markets which can devastate traditional "long only" portfolios. Protracted bear markets, like those of 1974-1982 and 2000-2003, may last for years. And it may take many more years for investors to get back to their previous portfolio high-water marks.
It is crucial that investors evaluate shorting unemotionally as an investment tool. In my opinion, when you are following a disciplined trading method, being long an index is just as risky as being short an index in an unleveraged manner. Rejecting the shorting technique is like choosing to fight with one arm tied behind your back, especially now that ETFs have made shorting a risk reduction tool for traditional investors, when used judiciously.
More on the book at Amazon; see also Must-Read Investing Books
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This article has 15 comments:
Let's assume, on any given day (or week, or even month),
a short position has approx the same risk/reward profile as a long position.
Expected volatility can be 5% in either direction, lets say..
However, shorting's risk/reward profile seems to be fundamentally different over any extended duration of time, particularly, if the amount of capital is not compounded/rebalanced (as it implicitly happens on longs)
Let's take a large stock movement within the dollar range b/w $3 and $24.
Case 1: Shorting a stock from $24 -> 12 -> 6 -> 3
1) If not compounded, you make 90%+ or so. By the end, you have a miniscule short position left. You're still short the same number of shares, but at a fraction of the original price. Since the market value of the position has decreased w/ the price, further 50% drops do not yield the same incremental profit. (Inverse compounding, if you will?) ie: You have not maximinzed/capitalized on a good trading idea, despite predicting a 21 point move.
2) Even if you maintain the original dollar amount as a constant (with additional shorting) all the way down. With $24 -> 12 -> 6 -> 3 , you still only made 230%, assuming you reinvest proceeds at the intervals stated.
3) Further, you can periodically reinvest ALL profits into the short, so, not only are you maintaining the original position dollar amount, you are letting additional profits ride as well, and increasing the dollar position size, as the stock drops. Even still, you do not get the same profit as being long if the stock moves up for the identical dollar range. (Theoretically, I think the continuous compounding concept/limit of "e" applies here? ie: Reinvesting at x% drops, even if done every 10%, or 5%, or 1%, or every penny. Even though this is not possible, in practice, I still am trying to see if shorting "can" be the same as going long, if you get the same dollar range movement. ie: You short everything, ever penny of the way down.
Case 2: On the other hand, being long from 3 -> 6 -> 12 -> 24 = 700%
Conc: As an individual (ie: not for hedging) long-term position,
seems shorting does not offer the same inherent "math".... for upside potential.
Apples/oranges ?
User 59428, I'm not telling anyone to short anything from this writing. It's just a tool.
The MOB spread [Munis over Bonds and visa versa] was popular years ago. Tax law changes impact it's use for example and now monoline insurance issues are having an impact. Obviously then being long Treasury bonds and short Munis is profitable. Yet the ability to short any muni ETF is probably impossible for retail.
And, as indicated, the bullish bias indicates stocks and indexes will rise over the long term but it's those pesky bear markets that hurt. Further, with new products from ProShares for example, shorting indexes is becoming not only easier but perhaps much more effective than the use of options whether for hedging or speculation. Preserving your wealth and asset base should always be an important consideration for any investor.
That's just plain wrong.
$100 -> $20 : 80% loss
$20 -> $100 : 400% loss
How is that the same?
Take Away : Learn mathematics for primary school before you comment on numbers.
when you lose money shorting indexes NOBODY has any sympathy for you
How-to books for Starting Hedge Funds, in 2008, are not so different from How-to Flip that House with no money down! books published in early 2007.
Shorting should always be a short-term special-situation strategy, It is is not for fools. I should know, I have lost plenty on it before learning (I hope) how to do it. right.
Our partnership has spent a year building a position in recession-resistant industries.
When the head & shoulders top in the indexes was confirmed, we laid on hedges short EFT indexes and index futures to protect the portfolio.
Now we are adding crash resistant stocks at support, and selling poor performers on rallies. The hedges are now the core position, since the bear has been confirmed....
scott w
growthportfolio.ning.c...
"where social networking meets investing"