Is it risky to trade short on stocks?

No trend and no bull market lasts forever. We have just seen how fast it can go downhill in the March crash. But how much sense does it make to shorten stocks?

On Sunday Harald published a short article on short selling (see here) and by chance I was also working on a “trading system” with which I wanted to take a closer look at market swings. To do so, I used the so-called Donchian channel, which in the end is nothing more than a band around the current prices, with the highest high and lowest low of the period under consideration being used.

This indicator may have become famous when turtle traders made a lot of money with it in the 1980s. In the following figure, you can see the Dax daily chart with a 10-day channel. The bottom line shows the lowest low of the last ten days, while the top line shows the highest high of the last ten days.

The prices are swinging!

As can be seen in this chart, the prices swing from the highest high to the lowest low. Depending on whether the extreme points rise or fall, an upward or downward trend results. The movements within the band reflect an essential law in the stock market. The fact is that every action is always followed by a reaction or, to put it differently, prices will not rise or fall forever, but there will always be counter-movements.

100% right and still no money earned?

The chart section shown here shows the crash of March 2020. Anyone who was short positioned here is likely to have earned an enormous amount of money in a very short time. Such events and the fact that prices cannot rise forever lead many traders to be happy to take on a running bull market. Sooner or later there will have to be a correction, that is as certain as the Amen in the Church.

From a purely statistical point of view, there is a 100% probability that you are on your side, because as we all know, prices cannot rise forever. The problem with this approach, however, is that despite a 100% probability, it is not said that we can make money with this way of thinking. If we enter a short position too early, there may be a certain correction at some point, but it does not have to run back to our (too) early entry price. The assumption that the market must correct is then confirmed, but the trader has earned nothing.

An example that can be seen in the chart was the buying wave in mid-May. Prices rose from 10,160 points to a new high almost daily. The strength of the bulls was enough for a sprint to almost 13,000 points before a correction lasting several days occurred. However, as this only reached up to approx. 11,600 points, short traders who entered at a lower level remained in the red. But even for traders who shorted at the end of May, not much remained.

Is it worth shorts in the Dax?

So much for a few basic considerations, but how does the DAX now look like with swings, even on the short side? With the help of the Donchian Channel we can pursue this question. In a first step, I entered at the closing price of the day long, where the Dax reached a new 10-day low, for example. As soon as the price rose to a new 10-day high, I turned the position to short. As part of a system test, I varied the period of the Donchian channel up to 250 trading days in steps of 5.

The result was that there were profitable trading approaches. But the question was where the profits came from. Therefore I tested the short side separately. The result is staggering (see following figure). Basically, there is no profitable approach where it is worth going short when the upper band is reached and holding the position until the lower band. Formally, the 5-day band is profitable, but if we add fees and co. to almost 400 trades over the last 20 years, there is nothing left. But even if we did, no one would take this approach because the profitability is simply far too low (see profit factor).

Let’s get to the point. Shortening stocks seems dangerous. Of course, there are always stocks that are also in long-term downtrends. But all in all, it could become problematic to short stocks across the board. It seems more sensible to trade stocks rather long. At least that is what the test here indicates. However, there is no doubt that this test does not claim to be absolutely true and suggests further tests. However, we will save these for later. On the basis of what we have learned so far, one guideline remains: concentrate more on the long side when trading stocks.


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