I always try to post a "How-To" on Sundays, as the slower pace of the weekend allows for some quiet contemplation. Given the significance of the start of holiday shopping, I almost skipped it — until I read Hedge fund manager Doug Kass good advice on what to do when you are short in the face of a robust rally:

"(With the possible exception of being a New York Jets football fan this season), few experiences are more painful than being short in a near parabolic rise in the equity market (like we have witnessed recently).

It is easy to rationalize either side of the market. It is harder to implement a strategy that reduces the overall impact of being wrong and attempts to take emotion out of the investment equation.

What follows are some lessons I have learned when I have been short in a rapidly rising equity market, as has been the case over the last few weeks:

1. Avoid averaging up on your shorts.

2. Buy some out-of-the-money calls to protect from further gains to the upside.

3. Cover shorts down to levels that you can sleep with — even reduce the number of your shorts in your portfolio by making some sacrifical covers.

4. If you have the charter, consider pairing some shorts with longs in the same industry or sector that are statistically cheaper than your short.

5. Go through the exercise of reviewing each and every short anew, and be objective in the process.

6. Work out, take a walk, or do some lifting. It will be refreshing, invigorating and will get your mind off the pressures associated with recent trading mistakes.

7. Finally, go back and reread some of the classic books on investing like Reminiscences of a Stock Operator.

That said, I don’t think the short side will be a long-term lease in the House of Pain. Not by any stretch of the imagination.

Good advice from a pro . . .

>

Source:
On Being Short in a Rising Equity Market
Doug Kass
Street Insight, 11/23/2005 3:36 PM EST
http://www.thestreet.com/i/streetinsight/editorspickssi/10254351.html

Category: Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

8 Responses to “On Being Short in a Rising Equity Market”

  1. Barry says:

    Interesting commentary. Doug is usually on the right side of the trade from the times I have seen him on CNBC. This long assault has been unusual. Breadth has been weak, new lows continue to be a problem, Copper appears to be in a blow off top, long rates are sliding and potentially signalling recession and the international liquidity equation is a potential problem. Is this the final run for the bulls or the start of something big to the upside? We’ll likely know within the next three weeks. All short term sentiment indicators are at or near corrective readings. The 17-28 day cycle run is about at its end and the market has had a very difficult time pushing the averages higher without what appears to be alot of extreme effort. Will this be a normal correction in a bull run or something more serious to scare the living bejesus out of the weak hands? Time will tell but I pick Door #2. I’m readying my short hand and its entry point as I write this. The only question is how far we correct. Lot’s of savory gaps to possibly fill. A 61% fib retracement will clean them all out and likely leave the uptrend in tact. ie, More of the start/stop market action we’ve seen for two years.

  2. PC says:

    Whether you are long or short, a good trader will ALWAYS know his stop loss uncle point BEFORE he enters into a position.

    So he should have “no need” to go through the list of reasons above. It’s very simple – when your stop loss is hit, you are out! No thinking needed (the thinking is done BEFORE you enter into a trade).

    If you find yourself needing to go through the list of reasons above to reassure yourself or make yourself feel better, you are trading on HOPE. And hope is a four letter word in markets.

  3. PC says:

    PS – Unless you are a short only fund, why are you short in the first place when the market is rising? The goal is to make money, isn’t it? So if the market is rising, you go long and stay long until the market turns down.

    Going short in a rising market, except in the case of short only funds, is trading your opinion and not price action. Trading your opinion usually ends up in a world of hurt.

  4. blue says:

    PC, I agree that knowing exit points is definitely on the “to do” list before placing the trade in the first place. But what I’m taking away from this list, as someone short this market, is that there is more information that has (and continues to) come between the time one places the trade and the point of capitulation, that’s what I think the moment of reflection is for. If you’re short a sector and individuals in the sector, and ‘things rise’ then do you continue to short certain individual stocks and let off on the sector, based on the market’s behavior since placing the initial positions. Or do you alter your time horizon, etc.
    -][

  5. PC says:

    Blue,

    Thanks for your comments. You wrote:

    “But what I’m taking away from this list, as someone short this market, is that there is more information that has (and continues to) come between the time one places the trade and the point of capitulation, that’s what I think the moment of reflection is for.”

    Is there really anything to reflect? You are in a trade and you have a stop loss point that tells you that you are wrong at that point and must get out. If you get out “before” that stop loss point, then you didn’t allow (1) the time and (2) the room for your trade to work prove itself right or wrong. If you don’t honour your stop loss and don’t get out when it’s hit, then you are in even more trouble.

    “If you’re short a sector and individuals in the sector, and ‘things rise’ then do you continue to short certain individual stocks and let off on the sector, based on the market’s behavior since placing the initial positions.”

    Paul Tudor Jones has a reminder on his desk that says,”Don’t average losses as only losers average losses.” The general rule in trading is if your positions show a loss, don’t add to it.

    “Or do you alter your time horizon…”

    There should be no time horizon to alter. You have a stop loss and that is. If you alter your time horizon, e.g. lengthen it, in order to alter your stop loss, then you are not sticking to your stop loss in the first place.

    My point is why complicate things with all these “post trade” thinking. It only gets your emotions more involved in a trade when there should be no emotions in it. Anyway just my two cents worth.

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  7. If someone is a rigorous technical trader, they probably have discovered that long-only systems work significantly better in stocks over long periods of time, so if your mandate isn’t a certain correlation profile (short-only, beta to some index), I recommend taking it easy on the short side.

    If you short more on fundamentals, it is important to recognize general regimes of multiple expansion and contraction. Likewise, situations where macro factors are pushing indicies, as opposed to earnings pulling them. These environments can make a mockery of your bottom-up analysis. This distinction is tricky, but one of the best ways to avoid being “too early”.

  8. blue says:

    PC,

    when i ‘short’ a stock, i generally buy put contracts that expire beyond my time horizon for the stock to trade down. if, or as, the stock goes up and causes my put position to fall in value, i have more and new information in general, but the possibility that the stock would rise is built into the original position. so if stock XYZ is at $50 and i think it could go to 35 within 3 months, i might buy puts that expire in 4-6 months out with a strike price of $40-45. paying say $2 for the 40s and $4 for the 45s. if the ‘target’ of 35 is hit, they would have an intrinsic value of $5 and $10. but if the stock rises to $55 then i would not add to those positions, i would take the new information that the chart is giving me, and any additional fundamental information and if $35 still seems doable i would start new positions with higher strikes, more like 45-50 and/or longer horizons perhaps more solidly on 6 months out.

    it’s the same way i buy long calls, as the stock rubs against a bottom (!) i buy contracts 6-12 months out, past key earnings reports, etc. a little out of the money, usually for $3 or so. if the stock hits a second bottom, and the low is not technically ominous, then i buy more of the same or if the low is low enough i take the opportunity to buy further out or lower strikes.

    buying ‘further out’ or different strikes gives me options
    when the stock ultimately performs as predicted, i can sell the nearer term contracts to collect profits and hold the others to let part of my position ‘ride’.

    if i didn’t add to my losing positions in this way, i would not have bought long AAPL calls when the stock was at $33.85 earlier this year because i had already started positions when the stock was at $37.

    on the other hand, i wouldn’t have added to my short positions in AAPL as it rose from 56 to 62 and again to 65.

    -blue][erring