Lessons on Trading the Short Side
A Summary of the lessons from Stock Market Wizards by Jack D. Schwager
Summary
Shorting is a critical element for nearly all of the traders in the Stock Market Wizards
The market is like a coin, which has two sides - But the coin is unfair. -Jack Schwager
With proper risk management techniques and strict adherence to the plan, short selling offers the opportunity to increase returns without increasing portfolio risk
Stock Market Wizards by Jack D. Schwager is a wonderful book that gives a glimpse into the mindsets, processes, and paths of some of the greatest stock market traders such as Steve Cohen and Mark Minervini.
My largest takeaways from the book related to the short side of trading. This is probably because my trades on the short side this year have been quite painful, and I needed to hear these essential lessons.
At first glance, (and in my experience this year) shorting seems to be an awful risk/reward. Many great investors have concluded that shorting a stock is a fool’s errand, not worthy of any attempt or implementation.
Why then, do 14 out of the 15 traders interviewed by Jack Schwager in his book, Stock Market Wizards, trade the short side? It certainly isn’t because they love losing money. Schwager breaks it down succinctly in his conclusion of the book.
The challenges of shorting stocks
Schwager first addresses the initial observations, that it seems the prospects of shorting are quite terrible and a real irritation (as Charlie Munger famously put it.)
Just as you can bet heads or tails on a coin, you can go long or short a stock. Unlike a normal coin, however, the odds for each side are not equal: The long-term uptrend in stock prices results in a strong negative bias in short selling trades. p.314
When looking at longer time-frames, it is clear from the data (and simple observation) that stocks generally go up and that being structurally short stock markets may not be a great trading strategy.
Source: Capital Group: Time, not timing, is what matters
Schwager further explains the negative risk/reward aspects of shorting.
Another disadvantage to the short side is that the upside is capped. Whereas a well-chosen buy could result in hundreds or even thousands of percent profit on the trade, the most perfect short position is limited to a profit of 100 percent. (if the stock goes to zero). Conversely, whereas a long position can’t lose more than 100 percent (assuming no use of margin), the loss on a short position is theoretically unlimited. p.314
This example from Schwager demonstrates the significant challenge that shorting presents. Even if you do the best possible analytical/technical work, and pick out the company that goes bankrupt, you’ve only doubled your money.
“Wow, Clark and Richie, nice job with the short Fisker idea… Now go find me 5 more this year so that it adds more than 50 bps to our P&L.”
Source: Benchwarmers (The greatest baseball movie, yes better than Moneyball)
Even further to this point, the best short ideas can take significantly longer time to research and dig to uncover these outstanding short selling opportunities. Some of the top short-selling firms do the most expansive research and often put long-biased firms to shame with the depth of research. One my my favorites, Hindenburg Research, puts out great work that I find fascinating to read and study. Their research is shared publicly on its site and X, I’d highly encourage anyone interested to follow it simply out of education.
If I haven’t already made you despise shorting, I’ll briefly touch on the final point Schwager writes about the disadvantages of shorting.
Finally, with the exception of index products, the system is stacked against short selling. The short seller has to borrow the stock to sell it, an action that introduces the risk of the borrowed stock being called in at a future date, forcing the trade to cover the position. Frequently, deliberate attempts to force shorts to cover their positions (short squeezes) can cause overvalued, and even worthless, stocks to rally sharply before collapsing. p.314
If you were a trader/investor during the last few years, you saw first hand the junkiest stocks go straight to the moon. We all saw the Meme Stocks craze make headlines and disrupt markets significantly, causing massive losses for short-selling shops.
Why nearly all of the Stock Market Wizards still short stocks
Although you may now be terrified to ever short a stock in your life, we will now examine why 14 out of the 15 traders in Stock Market Wizards still choose to incorporate short selling into their strategies despite the inherent risks and challenges.
The key to understanding the raison d'être for short selling is to view these trades within the context of the total portfolio rather than as standalone transactions. With all their inherent disadvantages, short positions have one powerful attribute: they are inversely correlated to the rest of the portfolio (they will tend to make money when long holdings are losing and vice versa). p.315
By zooming out and considering short trades at the portfolio level, we can begin to see how they may be essential to the overall performance and risk characteristics of the strategy. The point of correlation is obvious, but it’s critical to understand because of the intertwined nature of correlation and risk. One of they key elements of portfolio construction and diversification is to have certain assets zig while other assets are zagging. Short selling allows you the opportunity to make money while the rest of your long assets are losing money.
If a trader can make a net profit on short positions, then short selling offers the opportunity to both reduce risk and increase return. Actually, short selling offers the opportunity to increase returns without increasing the risk, even if the short positions themselves only break even. How? By trading long positions with greater leverage (using margin if the trader is fully invested) - a step that can be taken without increasing risk because the short positions are a hedge against the rest of the portfolio. p.315
Hopefully, it is now apparent why short selling can be an essential element of a strategy as it reduces the risk/return of the total portfolio and provides an important source of leverage.
So how does one implement short selling in a way that reduces portfolio risk and adds to returns, while managing the risk and avoiding “blow-ups” in single names? By doing just that, managing risk.
Schwager explains that through his extensive study of traders, the one indispensable rule of short selling is the follow:
Define a specific plan for limiting losses and adhere rigorously to it. p.316
The common plans for limiting losses, which I’ll cover in a second, are easy to understand in theory, but extremely difficult to follow in real-time. The most challenging part is adhering rigorously to your predetermined plan. I would submit that this is ultimately due to ego and pride. When a position begins to go against me, my gut reaction is that I’m right, my research is right, and this thing is eventually headed lower.
“Its just a squeeze!!”
Above is one of my more painful trades on the short side this year, where I clearly broke my rules and paid for it. I shorted SFIX at $2.43 on a strong breakdown after bad earnings. My stop was at 30%, which was around the $3.13 level. The next quarterly earnings it gapped above my stop level. I told myself it was just a squeeze, and that it was sure to come back down. I held on tight and didn’t cover. It then proceeded to grind higher for nearly a month before I finally got out at $4.12, a nearly 70% loss. Luckily, my position size was small enough that it didn’t cause significant damage to the whole account. But it certainly was a painful lesson that I won’t forget.
Schwager outlines three different risk-control methods based on his interviews with traders in the book:
A short position is liquidated when it reaches a predetermined maximum loss point, even if the trader’s bearish analysis is completely unchanged.
A short position is limited to a specific maximum percentage of the portfolio.
Short positions are treated as short-term trades, often tied to a specific catalyst, such as an earnings report. p. 316
As you can see from my experience, my original plan had all three elements, but lacked commitment and rigorous adherence.
Define a risk-management plan and follow it rigorously.
As always, nothing I say is investment advice, please seek advice from an investment professional on your unique situation. The writing is for informational and educational purposes only, and is not an offer to buy or sell securities mentioned. I may hold positions long or short in securities mentioned, and positions are often a small percentage of my overall portfolio. I will not be writing in a regular, predictable basis, please do your own due diligence on any topics mentioned.