Stock Index Shorts Have Extra Headwinds

Stock Index Shorts Have Extra Headwinds

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Investment performance is often benchmarked against the performance of a stock index. You might trade your account for one year and create a return of 15% on your original account balance. If in that same year, the S&P 500 is up 18%, then your benchmarked return would be -3%. You would’ve actually lost 3% versus a passive investment in the S&P 500 and created a lot of work doing so. Conversely, if the S&P 500 lost 2% for the year, your benchmarked return would be +17%. You created a return that was 17% higher than a passive investment in the S&P 500 index (15% minus -2%=17%). Depending on your style of investing and your risk tolerance, you may benchmark against the Dow or the Nasdaq as well, but why benchmark against the Indexes? Because stocks have an upward bias meaning; all else equal, they will always go up.

 

Good thing for us traders, they don’t always go up because it’s very rare that all else is equal, but nonetheless the bias exists. When shorting equities there are a few things you should know. According to The Long Road research group, in the last 34 years the S&P 500 has shown a 95% likelihood that losses are not going to be bigger than 1.78% on any given day and there is only a 5% chance of a 2.77% drop in the S&P. This shows very clearly the problems shorts have in the indexes). Since 2017 began, there have been about $170 Billion of inflows to domestic long-only mutual funds (although it has dropped off the last 2 months). These funds take all new capital every month and buy stocks, regardless of price. There are always those that look for drops in the indexes to “dollar cost average” which is a fancy term for what traders call “adding to a loser” and the buy and hold crowd will continue to do just that. Buy and hold. Given the way poor performing stocks are dropped from the indexes and better performers are added when re-balancing happens, it’s basically mathematically impossible for an index to go to zero.

The moral of the story is, if you are one of those traders that likes to short markets (those traders exist and if you are one, the first step in profitability is to look in the mirror and admit it) then avoid the stock indexes. Trade crude or gold or silver or FX or a market that doesn’t have a parachute on when it’s falling…and a back up motor to propel it right back up!

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