This is a cautionary tale about the importance of return objectives and risk control. Regular readers know that while my trading model has not be perfect, it has been quite good for swing trading purposes.
So far in the month of October, my main trading account is up 7.1%, while the SPY is -7.1%. I don’t write this to brag, but to illustrate a point. A secondary account that trades the exact same signals, but uses a more aggressive leverage ratio, underperformed at 5.2%.
This brings up my point about defining return objectives and risk control.
Short is not the opposite of long
Let’s start with the basics. A short position is not the opposite of a long position. David Merkel at Alphe Blog correctly pointed out the key differences:
I hate to short, because timing is crucial, and the upside is capped, where the downside is theoretically unlimited. It is really a hard area to get right.
Last note, I didn’t say it in the article, and I haven’t said it in a while, remember that being short is not the opposite of being long — it is the opposite of being leveraged long. If you just hold stocks, bonds, and cash, no one can ever force you out of your trade. The moment you borrow money to buy assets, or sell short, under bad conditions the margin desk can force you to liquidate positions — and it could be at the worst possible moment. Virtually every market bottom and top has some level of forced liquidations going on of investors that took on too much risk.
Short sellers also have an extra portfolio construction problem when it comes to the dynamics of position sizing. If you are right in your short decision, you have to short more stock as the stock goes down in order to maintain that position`s percentage weight in the portfolio. This issue is especially acute when managing long-short, or equity market-neutral, portfolios. Otherwise, the sizes of the long and short positions will be off balance.
Bear markets are more volatile
Short-sellers who take a directional, rather than hedged bet, face a different problem. If you make a directional bet that a stock or an index will fall, you will benefit if the market is undergoing a bear phase.
The follow observation may sound obvious, but bear markets are more volatile than bull markets. The chart below shows volatility, as measured by the VIX Index, has tended to spike when returns fall (bottom panel).
It was the higher volatility effect during bear phases that accounted for the lower return of the account that used a higher leverage. Even though the buy and sell decisions were mostly correct, the combination of slightly bad timing of a day or two early at inflection points, and the dynamic leverage varying trading system of the more aggressive account resulted in subpar returns.
This episode illustrates an important lesson for investors. Portfolio managers have two main decisions to make. What do you buy and sell, and how much do you buy and sell?
Both accounts had the same buy and sell decisions, but varied on positions sizing and timing. The main account took smaller positions, changed position sizes based decisions to either average down, or to selectively take partial profits. The more aggressive account took bigger initial positions, and found that when it came time to add to them, it was already at its maximum position size.
Sometimes less is more.
My recent experience has led to several key takeaways:
- Know your returns objectives: Investors need to know that outside of war and rebellion that cause the permanent loss of capital, equities perform well and a long equity position will yield superior returns in the long run. Under such conditions, investors can improve portfolio performance merely by sidestepping bear markets. In other words, some people don`t have to short the market. Holding cash, or an uncorrelated asset class like bonds, may be enough. You don’t have to be a hero and unnecessarily stick your neck out. It depends on your return objectives.
- Bear markets are more volatile: If you want to short the market, understand that even if you are right, the environment will be more volatile. Reduce your position sizes accordingly.
- Counter-trend position are riskier than trend positions: Traders can realize good profits on calling the primary trend. Counter-trend moves, by contract, tend to be more brief and therefore riskier. Adjust counter-trend positions in accordance risk levels.
Live and learn. I have re-aligned the risk management practices of the second underperforming account to conform with those of the first account.