Short Selling Trading Strategies – Is It Possible To Make Money With Shorting Systems?

Last Updated on May 20, 2022 by Quantified Trading

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).

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.

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).

The benefits of short selling strategies

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 them below:

Short selling 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 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 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 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.

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.

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.

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