As traders and investors we are bombarded with the message that selling short is “one of the most risky” trades we can place. I would argue that this is more theoretical than practical.
Let’s examine the risk of a long stock trade and a short stock trade. Textbooks state that risk is limited with a long trade since stocks can only go to $0. Other than a few unfortunate names, most traders have not had a stock go to $0 while they owned it. This is a low probability event. How many traders have held a stock that is down 20% for years and years hoping that it will come back to where they bought it?
Technically a stock can increase in price forever and ever as a result there is technically “unlimited” risk. This is theoretical in nature since we do not have any stocks that trade infinity as a price.
In the real world I would argue that a properly place short trade and a properly place long trade have the same amount of risk.
Let’s examine the process. Like any experiment you need to define your variables and perform the experiment within the parameters you have set up for the results to be repeatable by others and to isolate the effect of each variable. In trading this is your Trading Plan, you set your trading parameters and execute your trades based on those parameters so you can repeat the trades over and over again and have comparable results.
THE FALLACY
The fallacy of the risky short and risk free long trade is based on two contradictory assumptions, unlimited losses and unlimited profits, both very rare events. If we have a trading plan where we use stops and targets then long and short trades become equally risky. We don’t have the hope that our long trades will go up forever and remove the fear of our short trade rallying against us to infinity. By having a target and a stop, you define your risk and reward. Whether the long or short trades go against you your stop will take you out of the trade with the risk you have previously defined. Same with the targets, you will exit both long and short trades when your plan dictates.
BENEFITS OF SHORTING
Why trade short? It gives you a chance to profit when the markets go down, not just when they are moving up. I prefer the short side and have made far more money short than long. As the saying goes “Markets take the elevator down and the stairs back up.”
Trading long is generally a grinding process, the market goes up, pulls back a little, then goes up again making higher highs and higher lows. The retracements are generally small and most traders can hold through the retracements and catch the larger up move. Trading short is much different; the moves are fast and offer very few small retracements against the trend. The difficulty of holding short for a few days or weeks is that the retracements come just as fast and unexpected as the down moves, shaking traders out then returning to the downtrend.
THE BOTTOM LINE
What is the long and short of it? Trading long and trading short have the same risk if you have targets and stops set. Understanding how to limit risk is important to any strategy, the risk of the trade you’re putting on is more important than the theoretical risk of the trade set up. Trade within your risk parameters and you will never have to worry about a stock going to $0 or price going to infinity.
= = =
Learn more about Tristan’s market work here.
Do you trade stocks? Learn about legendary investor Bill O’Neil here in this exclusive interview.
