Stocks prices rise and fall all the time. How can we make money, irrespective of which way the market moves? Ideally this means having the stocks while they are rising and having a methodology to deal with the stocks when they are falling. This article concentrates on two types of investor: The Long Only Investor and The Short Investor.
THE LONG ONLY INVESTOR
The long only investor is simpler to understand. He holds stocks that he owns and he selects the stocks that will give him the best absolute return. Whether he trades in and out of the market or stays for a longer term in the market, he knows that he has one biased factor in his favor and that is that shares, as an asset class, can perform very well over the long-term. For example Jones and Wilson, calculated that real stock returns on the S&P500 averaged approximately 7% for the period 1926-2004 (The Financial Review: 2006)
The long investor wants to be in for the upswings, but wants to be well away during the downswings. The long investor likes falling shares, especially if: a) he does not have them; and b) they are exactly the shares he has his eye on to buy. Fundamental and Technical analysis will tell him if the stock is highly or lowly priced. The all important factor will be the timing of his execution.
The long only investor can choose to leave the market for certain phases in the year. For example, academic studies do prove that the simple “SELL IN MAY AND GO AWAY” strategy can greatly increase the returns of a Long Only Investor. Why do shares drop during these months? This is because the full year results have already been published; share prices have already peaked on that news; liquidity is low as traders are on vacation; and analysts shave earnings so firms can beat expectations later.
Where it is clear to the Long Only Investor that the markets are falling, e.g. in a Bear Market, then he may choose to hedge his portfolio. There are a number of ways of doing this, such as buying a Put Option or selling a Future Contract on specific stocks or indices. The degree to which you have insulated or insured your portfolio is measured by the “delta”. This comes from the Greek word for change. Therefore a delta =1 means that your hedge is a perfect match.
Unfortunately there are problems with the perfect hedging of portfolios. For example in Europe you may have a Dow Jones Stoxx50 index portfolio and want to hedge it, but you find that the Stoxx50 future is totally illiquid. You are forced therefore to sell a Eurostoxx50 future as a form of proxy, or alternatively use a mixture of EStoxx50, FTSE100, and Swiss Index futures. Things get more complicated when you have a 30 stock portfolio made up of an eclectic mix of industries, sizes and countries. Any attempt to hedge with a broad index derivative may open up exposures to new risks which are not apparent at first glance.
Portfolio insurance may not always be relied upon. The Brady Report on the 19th October 1987 Stock Market Crash investigated how the S&P could have fallen 20% on one day. One of the findings was that record margin calls accompanied the large price changes and contributed to an acceleration of the sell-off as liquidity was drawn from the market. Therefore you may have Portfolio Insurance, but it may fail in times of crisis. Furthermore Counterparty Risk always exists, even though it was largely forgotten in recent years. However, the Bear Stearns collapse may have changed all that.
You could of course take away the stress and technicalities of hedging by buying guaranteed return products, but in all honesty these products seem to me to be just ripping the bank customers off and I would not recommend then to anyone. Besides market departments always produce such products when it is too late.
A final way in which falling stock or sector prices can benefit the Long Only Investor is when these falling prices lead to something else rising, e.g. defensive stocks rise as the market falls; or gold stocks rise as inflation or dollar sensitive stocks fall. This is usually how the stock, sector and asset allocation processes function.
THE SHORT INVESTOR
The Short Investor basically sells what he does not own now, with the aim to buy it back at a lower price later. He is a much rarer type of investor for a number of reasons:
a) Firstly the short investor may need to obtain credit to borrow stock or to be able to trade futures on margin;
b) Secondly, as mentioned above the long term trend is against the short investor; c) In Bull Markets every long investor seems to be a genius, whereas in actual fact, they are just Beta investors; and
d) Bear Markets are the time when the short investor rules the roost, but the Bear Markets have generally been shorter and deeper than the Bull Markets
To short a stock you can either: sell a future, buy a put, or sell a call. You could even have 29 of the Dow Stocks in your portfolio and hedge it with a Dow Jones 30 future, so that you would have shorted Dow stock No. 30. There are many variations of how to short stocks and portfolios, but you need to be careful in trading derivatives as the leverage is so large that a mistake can be costly. Indeed there are many cases of companies (e.g. Metallgesellscaft Germany in 1994) discovering too late that their hedging departments have lost a fortune, because they simply did not understand what they were doing.
The explosive growth in Hedge Funds in recent years led to a sudden demand for Fund Managers. These managers were really Long Only Managers and had no experience shorting stocks in the market. The end result has been that Hedge Fund returns have been much poorer in recent years, with the customers paying big commission fees for long only managers, who were producing negative or single digit returns.
There was a proliferation of new absolute return products after the Bear Market Collapse between and 2003, but many of these had to be wound up and compensation paid to investors. This demonstrated that for all the sophistication of the new products on the market, the managers were still unable to successfully short the market.
As I mentioned above the Bear Stearns collapse has hopefully reawakened the existence of Counterparty Risk. This is a very important risk, which needs to be taken into account in using any derivative products to do short trades. So watch out with Bear Market ETFs and if you must buy them then spread them amongst various issuers.
If you can avoid shorting stocks then I would try to do so, but if you must then I will just make a suggestions: Always watch out for the dividend dates or the timing of important news releases or strategy plans which could cause the price to rise You need to have a proven logic and tools similar to a fundamental investor (Larry Williams) Never hold on to a losing position (Jesse Livermore) The successful trader has to fight 2 instincts: hope and fear (J. Livermore) Know the market and stock trend its your friend Make small bets to make big money (L. Williams) Focus on one area
CONCLUSION:
Shorting stocks is an area that should best be left to the experts, as huge errors can be made using derivatives. Besides long term equity returns do not favor short investors. Unless you have a very strong conviction, I prefer being a Long Only Investor and to hedge my portfolio against falling markets or in extreme circumstances exit the markets completely. More importantly falling prices should be used as an opportunity to buy what you want at lower price levels.