Truth About Short Selling [And What To Do Instead]

Oct 07, 2020

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When people hear the words “bear market”, many of them instantly think of short selling. They believe that shorting a falling stock is a simple way to grow their account. And they quickly start looking for stocks to short.

But for many people, short selling stocks is a disaster. In my last video, I explained four reasons why I believe most people should avoid shorting. If you haven’t seen it, make sure you go back and watch it… it could save you a lot of money.

In this video, I’m going to discuss the short seller’s biggest threat… the bear market rally. I’ll also tell you who wins in a bear market, and you’ll see example of how you could navigate this dangerous part of the market cycle.

Now, a quick reminder, if you’re new to my YouTube channel, make sure you hit the subscribe button below the video, and then click the bell icon to get notifications when I release new videos.

Okay, I’ve got a great graphic for you. Have a look at this… it shows every 30% bear market in the Dow Jones over last 100 years. There are nine in total. So on average, that one every 11 or so years. Now, have a look at each one. You’ll see they’re all unique…. the time it takes to reach a final low, and the path they take to get there, is different each time. Some bear markets are relatively short, while others drag on. There’s really no playbook for how these things pan out.

Now, if we ignore the 1929 to 1932 bear market, the average decline is about 40%. Now, this sounds like a big move, and it is. But if you want trade these moves from the short side, how are you going to do it?

Assuming you don’t sell at the high and you don’t cover your shorts at the low, that leaves the middle of the trend. But look at these moves, they typically zig zag lower. Even some of the smoother looking trends have big bear market rallies.

Getting short, and staying short, can be a difficult task. And when you weight the potential gain with the risk you’d probably need to take, the attractiveness of shorting can get pretty marginal. And remember, these are some of the biggest bear markets. How successful do you think the average trader is at shorting a correction or pullback?

Let me put this to you… for most people, the opportunity isn’t in shorting the market… it’s in identifying when to get back in. I’m come back to this in a moment. But first, lets have a closer look at a bear market.

Consider the most notorious bear market of them all… the great crash of 1929 through to 1932. After crashing 49%, the market rallied 48%. Now that’s a big bear market rally. Despite the big fall, a lot of shorts would have lost money during the initial crash and recovery.

Now look at the bear market rallies all the way down… 15%, 23%, 26%, 34%, and 25%. Don’t get me wrong, there are some big falls to short sell. And a good short term trader could make money. But the bear market rallies make it hard to stay on the down trend. Unless you have a take profit strategy, which also limits profit potential, the short covering rallies could eat into any profits.

From a risk/reward perspective, most people would be better on the sidelines. Here’s a more recent example…

This is the Australian All Ordinaries during the GFC. It’s the same sort of profile as the Dow during the 1930s. Lots of big falls with a series of sharp rallies in between.

So could you make money in this setting? Well, the answer is: Yes. But it’s difficult. You’ve got to time your entries almost to perfection… you then have to dodge the bear market rallies. And the payoff? Well, it’s potentially less than the risk of placing a short trade. That’s why short selling isn’t the free kick many people believe it is.

And remember, we’re looking at this graph in hindsight. We know lower levels are coming. You don’t know this in real time. Instead, many people think the bear market rallies are the start of a new uptrend. These are the conditions you face. You’re looking to place a trade, with a questionable risk/reward profile, in a volatile and emotion charged environment.

I believe the biggest reason retail traders fail is because they don’t fully understand risk/reward and, as a result, they chase marginal trades.

So who wins in a bear market?

Now what I’m going to say probably isn’t conventional thinking. Many traders believe they can use shorts to trade profitably during a bear market. Although this often isn’t the case.

The winner… the winner in a bear, and this applies to the vast majority of people, the winner is the person who losses the least. And the reason for this is that they have the most to invest when the bear market ends.

Remember what I said my previous video about asymmetrical risk. You need to ensure that the risk you take, produces a return that far exceeds the risk taken.

Just think about it, who’s likely to make more money… the trader who tries shorting a stock that zig zags its way to a 50% decline, or the trader who buys into an emerging uptrend that potentially rises by over 100%?

That’s why I use strategies that help keep me out during bear markets. My focus is to preserve capital when conditions don’t suit. And this sets me up to take advantage of high potential buying opportunities that require a relatively small risk.

And here’s another thing to think about… as a private trader you have an advantage…. you can decide not to play. Your typical bank or hedge fund trader doesn’t have the luxury to sit it out for a few weeks or months. There’s often a need to do something. Management don’t pay them to sit around. And this can lead to taking on marginal trades… I know… I’ve been there done that.

But as a private trader, you can choose not to play. And that’s an advantage.

So let me show you what I mean. This is how I aim to trade a bear market…

The graph shows two hypothetical trades in Commonwealth Bank. It covers a similar period to the previous chart of the All Ordinaries during the GFC. Now, you’ll see a label for Trade 1. This is an exit from an earlier trade. CBA hits its trailing exit point after the market turns lower. The exit protects capital from further share price falls.

Now, have a look at the moving averages at the top of the shaded area… they cross and turn lower. This means there can’t be any buy signals. Do you remember all those bear market rallies on the previous chart? You know the ones: up 16%, 18%, 17% and so on. They all occurred during the shaded area on the graph. Getting short and staying short is a difficult prospect. My strategy during this phase is to avoid the stock completely.

Remember what I said earlier, the winner in a bear market is the person who loses the least. By staying out of the market, I protect most of my capital. This puts me in the strong position when it’s time to buy. Here’s another chart for CBA:

This time I’ve highlighted the entry. You can see the final low on the chart. The rally initially looks like another bear market advance. Prices push higher and then begin to roll over again. It’s a pattern that’s been playing out for months.

But this time is different… rather than making a new low, the shares rally. This starts to feed through to the moving averages. They begin to turn upwards, indicating a potential trend change. With the odds now shifting to rising prices, I get a signal to buy CBA. Being able to identify favourable conditions is the key to long term success in the markets.

So be wary of trading short. I know it sounds exciting and it sounds logical. But volatility and the risk/return metrics make it hard to consistently generate profitable outcomes. For most people, buying shares is the better option. And if you can develop strategies to trade with the trend, let profits run, and keep losses relatively small, then you’ll put yourself in a position to potentially make a lot of money.

If you’d like to learn more about my strategies, I’m about to host a free skills accelerator course. I’ll be teaching 5 key tactics for identifying, managing, and exiting high potential stocks. You’ll find all the details at my website: motiontrader.com.au.

As always, if you enjoyed this video and thought it was valuable, then please click the like button and share it with your friends. And be sure to subscribe to my channel and click the bell icon for notifications. Thanks for watch, I’m Jason McIntosh, and let’s find some trends this week.

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