It hasn’t been a bed of roses for short-sellers lately. Over the past couple of weeks, “shorties” have been crushed by a fast and furious market rally.
As TheStreet’s James “Rev Shark” Deporre often notes, the biggest bounces tend to occur in the worst markets. “That is one of the main things that can make short-selling so difficult,” he said. “Even in the depths of an ugly bear market, an abrupt counter-trend move can destroy well-planned shorts.”
According to Rev Shark, the great appeal of short-selling is that it’s the best way to produce significant market outperformance in a bear market.
“Simply not losing money is a good way to deal with a bear market, but the way hedge funds make big money is by producing additional performance via short-selling,” Deporre noted on Real Money. “Hedge funds typically will underperform in bull markets but will more than make up for it with outperformance in bear markets.
The truth is, stocks do not go down in the same manner that they go up.
“The primary thing that traders need to know about short-selling is that bear market trading is not simply the inverse of bull market trading,” Deporre said. “If you use the inverse of bull market tactics in a bear market, then you are going to have a very difficult time.”
In reality, stocks tend to correct abruptly.
“There’s an old market saying that stocks take the escalator up and the elevator down,” Deporre added. “Anyone that has traded through a number of market cycles is aware of how months of hard-won gains can disappear in a matter of days or weeks when a market correction hits.”
Since short-selling requires a more anticipatory approach, it makes sense to build short positions incrementally and be ready to be on the wrong side of the trade for a while.
Timing Matters More to Shorts
In fact, one of the most difficult aspects of short-selling is it can be very grueling to be on the wrong side of the market for an extended period of time. However, when the bulls are the most confident and celebratory, it is generally the time when shorts should start to take action.
That’s why Rev Shark is not a strong short-seller for a couple of reasons.
“The first is that the focus is much more on timing,” he said. “I actively avoid calling tops and bottoms as I try to stay with trending action as long as possible. Short-sellers have to focus much more on predicting turning points because the drops are much more abrupt.”
Also, downtrends don’t last as long as uptrends. “Therefore the time frames for short-selling are usually much shorter,” he said. “Patience often works better for long positions than short positions because of the market's long-term upside bias.”
The easiest way to become a better short-seller is to cultivate a greater level of skeptical thinking.
“It has to be a conscious decision, and then once the decision is made, the appropriate tactics for dealing with a short need to be in place,” Rev Shark said.
Time Frame
Another major consideration with short-selling is the time frame.
“Long-term shorts of individual stocks is an extremely tough game to play,” he added. “Just ask those that have been trying to short Tesla (TSLA) for years. Even activist shorts that have compelling arguments can be destroyed, as those that went after GameStop (GME) and AMC Entertainment (AMC) found out.”
Investors and traders can navigate the market very well without ever short-selling, but it can greatly enhance returns if done right. Just be aware that short-selling is not just the reverse of going long.
“It’s a very different trading approach,” Deporre said.
