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:
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.