Short Selling Trading Strategies

Short Selling Trading Strategies (Risks, Pros, Cons, Backtest, Performance)

You can develop and create profitable short-selling strategies and systems, but you can’t expect to find many; they normally trade infrequently. This article presents several short-selling strategies in the S&P 500 (SPY and ES) and consumer staples (XLP).

Moreover, we explain the pros and cons of short selling and why it’s much more risky than buying or going long.

Table of contents:

Key Takeaways:

  • Profitable short-selling strategies are rare and trade infrequently.
  • Short selling is riskier than buying due to potential unlimited losses.
  • Effective strategies require backtesting and a deep understanding of market inefficiencies.
  • Diversification and hedging are key benefits of short-selling strategies.
  • Alternatives to short selling include buying put options for limited risk exposure.
Short Selling Strategies - Know the Risks Before You Short

Short selling trading strategies

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

We would also like to mention that we have developed a strategy bundle that consists of 3 short strategies, and we also have a long list of trading strategies.

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 when you sell an asset you don’t own in the hope of buying it back later at a lower price to capture the difference as profits. You sell first and buy later.

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.

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”.

What is naked short selling?

Naked short-selling is when you sell something you don’t own or have not located/borrowed. Naked short selling involves artificially increasing the float and is, of course, strictly illegal.

To avoid selling something you don’t own (naked short selling), your broker makes it impossible to sell something you don’t own or have borrowed.

Can you sell short futures contracts and other derivatives?

Yes, futures and derivatives are easier to sell short than stocks because you don’t need to locate or borrow what you sell short.

If you want to sell short derivatives, you simply sell them – even if you have not borrowed any contracts. Derivatives are a zero-sum game. For every contract, someone is long and short. If you buy an S&P 500 futures contract, someone else must issue that contract. If you make a profit, the counterparty loses.

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 on 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.

How do you develop a short strategy?

Short selling - Profits in falling markets

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?

Short selling is difficult because most markets usually go up. In the stock market, increased money supply and productivity gains have made stock rise about 10% annually.

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.

There are, of course, wide swings throughout the year, and a lot of stocks go belly-up. 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.

What are the risks of short selling?

The risks of short selling are theoretically unlimited because an asset can rise indefinitely, although in practice, the risks are smaller. Opposite, an asset can only go down 100%, limiting the downside.

If you buy a stock, the stock price can theoretically increase unlimitedly. 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.

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 short covering?

Short covering is when those who are short need to buy back their position to cover their shorts. The short seller needs to buy back the shares he or she previously sold short to return them to the broker/lender. If he or she is short 1,000 shares, he or she buys back 1,000 shares in the market to cover or liquidate his or her position.

Short covering can lead to a short squeeze:

What is a short squeeze?

A short squeeze is when the short-interest ratio is high and forces or squeezes those who are short to buy back their shares.

This means many short sellers must cover their position if the price increases. 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 and 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.

To better understand a short squeeze, we quote from Niderhoffer’s best-selling book:

I signed my first client and proceeded to short my first stock. It almost proved to be my last. Over the next few weeks, I watched the stock trade up to 20, then 30, then 40, finally breaking through 50…..But when the stock climbed past 50, I started to cover, unable to stand the pain. It was too late, however, a major bear squeeze was on. I covered the last of my position between 90 and 95. I lost the entire initial $25 000 stake plus $50 000 more…..A month after we closed out our position, RH Doe declared bankruptcy. One day, shortly after the Hoe debacle, I was moping along Broadway when I ran into Wilton (“Wink”) Jaffee, and old Wall Street hand and a veteran of many campaigns. As we talked, I blurted out something about “The biggest boom and bust cycle I’ve ever seen in a stock was in Hoe”. Wink replied with a chuckle, “Oh yeah, we had some fun squeezing the shorts on that one. Really took some of those midwestern hayseeds to the cleaners.”

– Victor Niederhoffer, The Education of A Speculator, page 267-268.

What is a stock that is hard to borrow?

A stock that is hard to borrow is difficult to sell short because you can’t locate borrow shares to sell short, or you might have to pay a lot in fees and interest to borrow.

Every broker has a list of stocks that are either easy or hard to borrow. As written earlier in the article, you need to locate shares before you short them by selling them in the market.

Those investors who own shares might agree to lend them out to short sellers. For doing this, they receive interests, usually split between the broker and the investor (the broker pockets the most). This means the broker’s ability to short stocks depends on both their clients’ holdings and their willingness to lend out their shares.

If the supply is short, the broker might have a deal with another broker. It’s a network effect. Those brokers who have the biggest inventory attract the most short sellers.

Hard to borrow means that the stock is difficult to short, and you can expect to pay more for the privilege of shorting. When a stock is hard to borrow, you need to pay more to locate the stock. This means the interest charged increases.

Below is a copy of Interactive Broker’s inventory of Coca-Cola:

Hard to borrow stock
Hard to borrow stock

More than 10 million shares are available for shorting, making Coca-Cola easy to borrow.

What does it cost to short
What does it cost to short

A stock that is easy to borrow has low fees.

A stock that is hard to borrow normally has high fees and interest, like shown below for Gamestop:

Gamestop short squeeze
Gamestop short squeeze

The costs of shorting are substantially more costly in Gamestop than Coca-Cola.

What factors influence the costs of selling short?

In general, the factors that influence the costs os selling short are the Fed Funds rate, liquidity of the shares, the short interest as a percentage of the daily trading volume, and the short interest compared to outstanding shares (brokers are afraid of a short squeeze).

What is a good shorting strategy?

A good shorting strategy is one that generates returns that are not correlated to the overall stock market. Furthermore, it might also help to mitigate risk and reduce volatility.

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 usually 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 many new traders still don’t fully appreciate or understand that a strategy that performs mediocre on its own can increase a portfolio’s returns. We recommend reading Mark Spitznagel’s Safe Haven Investing to better understanding why.

Pros and advantages of a short strategy

Let’s look at the most apparent benefits of a short-selling trading strategy:

Diversification

Someone who has proved himself as a successful short seller will be in great demand among institutions. The reason is simple: diversification.

Adding a fund/asset that goes the opposite way in bear markets greatly benefits a long portfolio by smoothing returns and increasing the “efficient frontier”.

A pension fund might allocate 3% to a short-only fund to reduce losses when the markets fall. Please read correlation in trading and Mark Spitznagels’s Safe Haven Investing to understand the importance of risk diversification better.

Reduced volatility

Because of diversification, a portfolio most likely reduces volatility and even increases the annual return (CAGR) if you have a good short strategy. To understand this better, please read the difference between arithmetic and geometrical returns.

Short strategies hedge your portfolio

Perhaps needless to say, but being short offsets losses in long positions. In a bear market, you reduce losses.

Cons and disadvantages of a short strategy

Let’s look at the most obvious drawbacks of a short-selling trading strategy:

You are betting against the upward drift

The stock market has, over the last 120 years, an annual return of close to 10%, according to Dimson, Marsh, and Staunton in the Triumph of the Optimists.

When you are short, you are betting against the upward bias. You are betting against innovation, inflation, corporate profits, and perhaps even multiple expansions. Add to this borrowing costs and fees and you understand the odds are stacked against you.

Or is it?

Hendrick Bessembinder published a study a few years back that revealed just a few stocks contributed to the long-term tailwind in stocks. This is further “proven” by the fact that most retail investors perform poorly and lag the indexes a lot.

Short has limited upside and unlimited downside

A stock can rise unlimited, but can only fall to 0. Thus, the risk and reward are not symmetric.

It costs money to borrow shares

You need to pay interest on the shares you borrow to sell short.

Shorting is painful

As usual, Charlie Munger offers some insights about short selling: “Is the pain, worry and mental distractions of shorting worth your time?  It is not that “hard” to make money somewhere else with less irritation.”

Short sellers attract the wrong shareholders

It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell.

– Mark Leonard, Constellation Software, shareholder letter 2013

The shareholder base is an underrated aspect. A business owner doesn’t want his company exposed to activists. Short sellers are mainly speculators and activists, and they never think long-term. Short squeezes are destructive and counterproductive, thus scaring off many long-term owners.

Warren Buffett has spent considerable time educating his shareholders. He wants them to think like owners. If you’re a long-term investor, you shouldn’t spend any time thinking about shorting.

Stocks and markets fall hard and fast

A bear market happens suddenly and doesn’t last long. The stock market discounts a bleak future rapidly, while a bull market rises slowly and over time.

In our article about the 200-day moving average, we calculated that the S&P 500 has spent 70 percent of the time above the 200-day average since 1960 and 85% of the time since 2010.

Here is a personal anecdote: when we were day trading in 2008, our best year, the market was down 55% at the most. Still, we made 2x the amount on the long side compared to the short side.

Why is that?

It’s because of the velocity of bull and bear markets. Bear markets are very explosive.

Let’s look at some data in the S&P 500 from May 2008 until the bottom in early March 2009, when the index lost 50% of its value:

  • 99 days were up and 104 days were down.
  • The average up day was 1.79%. The average down day was minus 2.32%.
  • It was 51 days with a rise >1%, 30 days with a rise >2%, 76 days with losses >1%, and 45 days with losses >2%.

As you can see, there were plenty of great long days even though the market fell a lot. This makes short selling difficult! Volatility explodes during bear markets.

Below is the graph showing a 25-day moving average of the absolute values in the daily changes from close to close:

A short trading strategy is hard to find
A short trading strategy is hard to find

Short requires volatility to make money

When the S&P 500 is above the 200-day moving average, the daily volatility is 1.05%. When the index is below the average, the volatility increases to 2.1%.

Clearly, the price action is completely different depending on the price being above or below the long-term moving average. It’s a lot more difficult to make money when stocks are trading above their 200-day moving average, which is a bull market. You need volatility to make money on short trading.

Selling short involves opportunity costs

Time spent chasing tops in the market might be much better spent in developing low-hanging fruit from the long side. Opportunity costs are about allocating money and time. Why go for the third-best option if you can add to the best option?

Short is betting against the “casino”

Casinos make money because they use the law of large numbers. They make a small profit on each roll of the dice or wheel. Because so many go to the casino to play, they are practically certain to make money in the long run.

If you are shorting stocks or you are a permabear, you are betting against the casino. Selling short involves a great deal of luck and timing. Some investors got famous for predicting the crash in 2008, but hindsight is everything. Every day there are people predicting crashes, and some will eventually be right.

We have been trading for 20 years, and we long time ago concluded that it’s extremely difficult to find a consistent short-selling strategy that works – in any market. Profits are mainly due to chance and luck. Additionally, short selling only works a small percentage of the time. Don’t believe you are a genius if you accidentally manage to call a top.

The best way to make money in the markets is by finding strategies with low volatility (high profit factor and Sharpe Ratio). If you manage to find a portfolio of uncorrelated strategies, the holy grail of trading, you can perhaps add a little leverage to your trading. Chasing short opportunities and timing tops leaves you prone to left tail events and costly mistakes.

Are there alternatives to selling short?

Yes, there are alternatives to selling short and buying a put option is the best alternative.

Because of the unlimited risk when selling short, we recommend another alternative that has limited risk:

You can buy a put option. When you are long a put option, you can only lose what you paid.

A put option offers you the right to sell a stock at a predetermined price (but it’s not an obligation). You need to pay a premium to the issuer (remember, the derivatives market is a zero-sum game) for the rights to this insurance. The option premium is dependent on many factors, the most important being the price of the underlying asset, the volatility, and the time until expiration. Even though it’s a long position, you benefit if the price of the underlying asset drops.  

The main advantage is obvious: you can only lose the premium you paid. For example, if you paid two dollars per option contract, which equals 2,000 USD for 1,000 shares, your max loss is 2,000 USD. Compare this to being short Gamestop and face forced liquidation or margin calls!

If the strike price of the put option is 100 and the price of the underlying stock is at 80 at the expiration date, you exercise the option (of course) and sell it for 100.

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:

Short trading strategy
Short trading strategy

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 to enter and exit positions at the close

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):

Short trading strategies
Short trading strategies

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 much 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:

Short trading strategy SPY
Short trading strategy SPY

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):

Short trading strategies SPY
Short trading strategies SPY

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 strong, 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

Short selling strategies
Short selling 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?

You can short-sell intraday, and 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 that the best indicator for selling short is mean revertive. The stock market is not very susceptible to trends, and anything that is oversold or overbought offers the best opportunities for

Can you short sell for the long term?

You can short-sell for the long term, but 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 in the long term for forex.

How do you tell if a stock is being shorted?

You find out if a stock is being shorted by looking at broker-dealer short position reports, which are required by law to report 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.

Famous short-sellers

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.

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, market regimes and asset classes offer better risk and reward during certain time periods and markets, as we have explained in this article. But always remember that any short trading strategy must be judged on its contribution to your overall portfolio of strategies in terms of diversification and correlation.

FAQ:

What is short selling, and how does it work in the stock market?

Short selling is when you borrow shares from your broker, sell them in the market, and later buy them back to close your position. Short selling involves selling something you don’t own, aiming to sell high and buy low later.

The process includes borrowing shares, selling them in the market, and buying them back later to pocket the difference.

For derivatives, you don’t need to locate and borrow shares to sell short.

Can you develop profitable short-selling strategies?

You can develop profitable short-selling strategies, but the odds are stacked against you because of the long-term rising trend.

It’s possible to develop profitable strategies, but such strategies are challenging to find and often trade infrequently. This article explores several short-selling strategies in the S&P 500 and consumer staples.

Can short selling be profitable in the long term?

Short-selling can be profitable in the long term but it depends on the market and asset class. While it’s challenging to make money short-selling stocks, forex markets offer a more favorable environment for long-term short strategies. Some short-selling strategies are those focused on consumer staples (XLP) and S&P 500 futures (ES).

How does short selling work with futures contracts and derivatives?

Short selling with futures and derivatives differ from short selling in the stock market because they can be sold short without locating and borrowing the contracts. Derivatives operate on a zero-sum game, with someone being long and short for every contract.

What are the pros and cons of short selling?

The pros of short selling are mainly risk mitigation and uncorrelated returns, while the cons are that risk is unlimited and you are facing headwind from rising prices.

Why do investors short stocks?

Investors may short stocks to profit from anticipated price declines, hedge against market downturns, or diversify their portfolios. Short selling can also be a way to express a bearish view on a specific stock.

Why is shorting considered risky?

Shorting is risky because while potential gains are capped at 100%, losses can be unlimited. Additionally, short sellers may face short squeezes, where rapid price increases force them to buy back shares at higher prices.

Why is short selling in the derivatives market different from the stock market?

The derivatives markets differ from the stock market because derivatives are a zero-sum market where for every contract, there is a long and a short position, whereas in the stock market, you need to locate and borrow shares to sell short.

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