Last Updated on October 24, 2022 by Oddmund Groette
Short selling strategies are very difficult to find. But when you find one, the strategy might be one of the most useful and enjoyable. Enjoyable because is there a better feeling than making money when the market drops? Most people are losing, while you are making money. Schadenfreude is hard to get rid of. But is it possible to develop short-selling strategies?
Yes, you can develop and create profitable short-selling strategies and systems, but you can’t expect to find many and they normally trade infrequently. This article presents several short-selling strategies in the S&P 500 (SPY and ES) and consumer staples (XLP).
In this article, we look at what short-selling is (short-selling for dummies) and we look at some specific short-selling strategies.
What is short selling?
Short-selling is almost the opposite of buying. We write “almost” because it involves one step more than buying, at least in the stock market.
Short selling is when you sell something you don’t own. The aim is to do the opposite of buying: sell high (first) and buy low (later). However, you can’t create shares out of thin air so first, you need to borrow shares from your broker, sell them in the market, pay fees and interest, and later buy them back and pocket the difference. This is how it works in the stock market.
In the derivatives markets, this is easier because it’s a 100% zero-sum game: someone’s gain is someone else’s loss. You don’t need to locate anything, you just sell to a buyer.
Short-selling examples (how does short trading work)
To better illustrate how short-selling works, we’ll guide you through two short-selling examples:
How to sell short stocks
Let’s assume you want to sell short 1 000 shares in Apple. How do you borrow a stock to short sell?
You type in the ticker code AAPL in your trading software and you might click s”sell” or “short”. If your broker has a huge inventory of Apple shares, which is unlikely, you borrow 1 000 shares from this “pool”. You have borrowed shares, and you sell them in the market for the prevailing market price at that moment.
After a few weeks, you decide you want to close your short position because the Apple share has fallen 11% since you sold them short. You want to lock in profits. You buy 1 000 shares in the market and you hand back the shares to your broker.
On a side note: How do brokers make money on short selling? When you are a customer of a brokerage you get asked if you allow your shares to be lent out to short-sellers. You get a fee for this. At Interactive Brokers, you get just a small fraction of the proceeds so this is a very lucrative business for the brokers. If you want to short sell for swing trading, this means you need to overcome the fees as well. You face many obstacles to becoming a profitable short seller!
How to sell short in derivatives
Let’s assume you have a portfolio of stocks and you are hell-bent in your belief that we are standing in front of the abyss. Inflation, war, and social unrest don’t bode well for future stock returns. You have decided to short one ES mini contract (S&P 500).
How do you do that? You simply sell one contract in the market. Your position will read -1 and any rise in the ES contract will be a loss.
The difference between stocks and derivatives is that stocks have a limited supply of shares and thus you can only sell short what is available to short. Opposite, in the derivatives market a contract is just a bet between a buyer and a seller.
What is a short trading strategy?
A short strategy is when you sell something short in anticipation of the relevant asset dropping in price. As described above, you borrow shares from someone else and sell those shares in the market. If the price drops, you can buy back later at a lower price and pocket the difference. Or, if you are operating in the derivative markets, you can just sell and get a “deficit”.
How do you develop a short strategy?
Short strategies are much more difficult to develop than long strategies – why is described below. However, it’s not impossible, of course.
A good starting point is using backtesting and quantified strategies. It’s all about finding inefficiencies based on statistics and numbers. You form a hypothesis, make rules, and then you backtest the hypothesis in trading software.
Are short strategies the opposite of long strategies?
You might wonder: If I have a good long trading strategy, can’t I just switch the rules and do the opposite?
Unfortunately, at least in productive assets like stocks, it doesn’t work like that. Because stocks have a positive overnight edge, you face a serious headwind.
In forex and currencies, you might stand a better chance with this approach. Despite this, you can’t expect opposite rules to work. You can try, but the chances for it to work is slim.
Why is short selling difficult?
It’s always more difficult to make money on the short side than on the long side. The only exception to this is forex which is a relative difference between two countries’ currencies.
Why is short selling difficult? It’s difficult because most markets normally go up. In the stock market, increased money supply and productivity gains have made stock rise about 10% annually in aggregate.
There are, of course, wide swings throughout a year, and a lot of stocks go belly-up. As a matter of fact, most stocks perform much worse than the averages. The returns are mostly negatively skewed and only a few stocks end up beating short-term Treasuries during their life as a public stock, according to a famous study by Hendrik Bessembinder in 2017.
Furthermore, most markets spend more time drifting up than down. Bear markets drop quickly, something we have covered in detail in the anatomy of a bear market.
We will not get into more details about the disadvantages of short selling, but we recommend our long article called why short selling is difficult (the article also lists the many advantages of selling short).
What are the risks of short selling?
If you buy a stock, the stock price can theoretically increase an unlimited amount. Phillip Morris, one of the most successful stocks of all time, has risen about 14% annually for over 100 years. This is thousands of percentages in returns!
Opposite, if you shorted Phillip Morris, you would have lost an equal amount of annual returns. The losses would have been staggering, Consider this to the maximum potential reward: 100%.
This means that you face unlimited risk, while only having a limited upside potential. This is what Nassim Taleb would call tail risk strategy, but unfortunately, the tail risk is not to your advantage.
What is a short squeeze?
A short squeeze typically happens when the short-interest ratio is high. This means many short sellers need to cover their position if the price goes up. Why do they need to cover their positions? Because many need to commit more margin to their position(s). This means that a lot of fuel is added to the fire and the price might go up – a lot. However, developing a short squeeze trading strategy is difficult because squeezes are rare and a high short interest ratio indicates poor long-term returns.
But short squeezes are rare, but they happen less frequently than you imagine. The reason is that they get a lot of press coverage and thus it feels like they happen frequently. Empirical studies we have read clearly state that a high short interest ratio is a sign of poor future performance.
What is a good shorting strategy?
Perhaps the main purpose of selling short is to generate returns that are not correlated to the overall stock market. Obviously, when stocks are going down and most investors are losing, you gain if you have some short positions.
Most likely, short-selling strategies give you poor trading metrics if you look at the strategies in isolation. However, the main idea with any trading strategy is to get good risk-adjusted returns for a broader portfolio:
The pros and cons (advantages and disadvantages) of short selling strategies
The main argument against short selling is that you most of the time face a headwind. Additionally, you most likely also pay interest on the amount you are short.
But even though a short trading strategy shows mediocre results on its own, it can add valuable advantages and benefits via diversification, risk mitigation, reduced volatility, and hedging.
Most of these advantages are pretty obvious, but still many new traders don’t fully appreciate or understand that a strategy that on its own performs mediocre can increase the returns of a portfolio. We recommend reading Mark Spitznagel’s Safe Haven Investing to get a better understanding of why.
Because short selling is so valuable we don’t want to reveal the few short strategies we employ. A few of them will be published to our paying subscribers via our monthly Trading Edges, but we briefly describe some short-selling strategies below:
Short selling trading strategy no. 1
One of our favorite trading vehicles is the ETF with the ticker code XLP. It tracks the consumer staple and is one of the most boring instruments around. But remarkably, it’s one of the few ETF’s that seems to be reasonably consistent by shorting. We have described why we like XLP in an article called XLP trading strategies.
The log scale equity curve below shows how our three short strategies have performed over the last two decades:
The average gain per trade is about 0.4% before slippage and commissions, something that equals an annual return of over 6%, just slightly below the buy and hold return by owning it. The win rate is 75%, but the average loser is 0.1% higher than the average winner. Overall, these are pretty good numbers.
Some readers might ask about commissions, slippage, and when to enter the trade. We use Interactive Brokers and we pay close to zero commissions.
We have also compared our trading journal with the results from the backtests, and we can confirm that we have practically no slippage in live trading in XLP. As a matter of fact, we obtained better prices in our live trading compared to the backtest during our test period!
Most of our backtests buy and sell at the close. This is impossible to replicate 100% because we only know the closing price after the fact, but this article describes how we do this in practice:
Short selling trading strategy no. 2
Below is another short trading strategy that we employ in the S&P 500 futures (ES). This is a day trade and trades infrequently and it has experienced long periods of zero returns (the backtest is in SPY):
The average gain is about 0.19% per trade and the win ratio is rather low at 56%, but the average winner is bigger than the average loser.
Short selling trading strategy no. 3
Short trading strategies perform better in stocks when volatility picks up. Short-term traders need prey to make money, and volatility brings a lot of energy to the market ecology.
Increased volatility normally means uncertainty about the future value of stocks and investors demand a higher risk premium to own stocks. This ends in lower prices. In our article about the 200-day moving average we wrote that the daily volatility is 1.05% when the S&P 500 is above the average, while it increases to 2.1% when it’s below the 200-day moving average. Short strategies perform better when volatility is high!
Below is a strategy that shorts at the open and holds 2-5 days:
It trades on average once a month and the average gain is 0.3%.
Here is another one that trades both long and short and has close to symmetrical variables (but opposite, of course):
Here is Amibroker’s backtester report:
Both long and short only trade during what we define as “bear” markets. Long normally performs very well in bear markets, but the difference is that shorts also work pretty well during such markets.
Short selling trading strategy no. 4
Let’s end the article by briefly mentioning a useful trading tool you can use for your shorts: seasonal trading strategies.
Every asset has historically strong and weak periods. For example, stocks have the Santa Claus rally and the Thanksgiving effect. The holiday effect in stocks is in aggregate strong periods, but there are also many weak periods, for example, the week after options expiration. We strongly advise using seasonal effects as part of your strategies and backtesting.
Buy short strategies
We have put together a special package or bundle of 3 short strategies for the S&P 500. These are strategies you will most likely not find anywhere else!
Can you short sell intraday?
Day traders frequently use short-selling strategies. In the stock market, it’s more rational to short the shorter the time frame is. The reason is that stocks perform worse from the open to the close than from the close to the next open. Thus, you face better odds the shorter the time frame. In other markets, it might be different.
Most likely, the best day trading short selling strategy is fading a stock that is overbought at a certain time of the trading day. The time of the day is a crucial factor when shorting due to the “seasonal” factors in the markets. However, this is something that needs to be backtested.
Which indicator is best for selling short?
We argue the best indicator for selling short is one that is mean revertive. The stock market is not much susceptible to trends and anything that is oversold or overbought offers the best opportunities for
Can you short sell for the long term?
This depends and if you want to be profitable or not (we assume you want to make money). In stocks, it’s hard to make money long-term because stocks get a tailwind from inflation and earnings growth.
In zero-sum markets like currencies, the situation is different. Forex is a zero-sum game and is all relative between each currency pair. Thus, it’s possible to make money even the long term for forex.
How do you tell if a stock is being shorted?
Broker-dealers are required to report their short positions twice a month. The reports cover both the inventory for the broker-dealer (what they have on their own books) and the positions for all their customers. You can look up the number of shorted stocks by using Google.
Based on this, you can calculate the short interest. This number is based on the number of outstanding shares that are shorted. If a company has 100 million shorted shares and the total number of issued shares is 5 billion, then the “short interest” is 5%. This is called the short-interest ratio.
Apart from the short-interest ratio, we are not aware of any other method to tell if a stock is being shorted.
One of the most famous short-sellers is Micheal Burry. You might recognize the name (?). Micheal Burry was one of the main characters in The Big Short, the movie about the financial crisis in 2008/09.
Another short-seller activist is David Einhorn. His hedge fund, Greenlight Capital is one of the most successful funds of all time and this is more remarkable when we consider that much of the gains have come from shorting stocks.
Another short-seller is Dana Galanta. She was interviewed in Jack Schwager’s Stock Market Wizards and was ONLY shorting stocks. However, she has not been much in the limelight lately and we are unsure of her most recent track records.
We have plenty of trading biographies on this page:
Short trading strategies – ending remarks
Short selling is a slightly different skill compared to buying. Theoretically, you are facing unlimited risk and losses, and you are highly likely to fight against the long-term trend – which is up, at least if you are operating in the stock market. Whether or not short selling is profitable is up to the preparations you make (you need to backtest).
However, there are market regimes and asset classes that offer better risk and reward during certain time periods and markets as we have explained in this article. But always keep in mind that any short trading strategy must be judged on its contribution to your overall portfolio of strategies in terms of diversification and correlation.