I'd like to discuss shorting for a second. I only recently started really digging into shorting and how it operates, but I'd like to clear my head of a few notions and see if anyone else comes to the same conclusion. I'll number my thoughts: 1.) Price can go up to infinity, and can only go down to zero. Price cannot ever become negative in magnitude. 2.) Taking a long position, you assume a reward of potentially infinity, and a risk of your account going to zero. 3.) Taking a short position, you assume a reward that approaches some limit as the underlying asset's price goes to zero, and a risk of potentially infinity. Let me state #3 in another way: with a short position, your gains are limited to how far down a price can go before it hits zero, and ITS RISK IS INFINITY. This is inherent behavior of taking short positions, but I somehow don't think many people fully grasp the magnitude of this: If you short a $100 stock, and its price suddenly quadruples over night (very rare possibility, but let's entertain the thought for just a moment), then you owe the brokerage $100 (the $100 you were given as proceeds when the short was initiated) and also an additional $300 that you may not have had in the first place. Let's say we have a decent algorithm that has been running for years, and you've managed to amass nearly $100,000 from taking alternating long and short positions. This is fantastic. However, be aware that if you fully leverage your account towards a short, you are making yourself extremely vulnerable to losses when flash price shifts occur. If, for example, you set a trailing stop on a short at 2% loss, then a massive price shift occurs in the market to increase the price of the underlying asset by 50%, your algorithm will do a simple comparison and say: "hmm, 50% loss is higher than 2%, so we'd better stop these losses". It then cashes out the short and you're on the hook for paying out 50% of your account's value. This is an extreme case to be sure, but not so extreme when you find yourself with a large-ish amount of money and alternating long and short positions using full leverage on a stock that is volatile in nature (micro cap companies, etc.). For these volatile stocks, its not unheard of for pump and dump schemes to conduct a hit and run, drive the price up by 10x, then leave. By that point, your algorithm's trailing stops might have inadvertently screwed you over by realizing those losses in an attempt to save your account, but failed to do so quickly enough. If you fully leveraged $100,000 on a short in THIS scenario, you'd be on the hook for over a million dollars! I just want to plant the seed in everyone's mind that, if you've crafted a clever algorithm that makes use of shorts, to be very careful about full leverage of your accounts. As your portfolio value increases, so does the danger. Thanks for listening :-) Link for consideration: http://www.marketwatch.com/story/help-my-short-position-got-crushed-and-now-i-owe-e-trade-10644556-2015-11-19
JP B
Thanks for sharing. I think you captured the biggest danger with shorting very nicely. I didn't look at your link initially but immediately an article came to mind that I read a while back. I typed in "short lost 100k" in Google and it was the first link. I only realised you also posted that link after coming back here :) But yeah, that is a notorious exampe of a 'short went bad'. Proper risk management and staying away from the small- to micro-caps should go a long way in preventing something like this from happening to you. But in any case, "Learn from the mistakes of others. You can't live long enough to make them all yourself". I hope you prevent somebody's biggest mistake with this lesson :)
Stephen Oehler
Thanks! And yeah, that $KBIO trade is the stuff of nightmares. Amassing a large portfolio value with a clever algorithm can lure one into a false sense of security. Ironically the more successful you are, the more vulnerable you are to an errant short. With longs, at least you know you can't do worse than just losing your portfolio. With shorts, you can go into debt.
Jonathan Evans
As an option to shorts, I've been looking into using Inverse ETFs as an alternative -- especially for accounts (like IRAs) which cannot trade on margin. They have some shortcomings themselves, of course.
Stephen Oehler
I wrote down your comment on a sticky note and put it with the rest of my "good to know" notes, Jonathan. Very good advice. I wonder if anyone in the trading universe has identified nearly anti-correlated ETFs that one could use as a functional short position? That would be incredible. A cursory google search shows that XIV seems to operate fairly antagonistically to VIX, for example.
Jonathan Evans
JP B
Stephen Oehler
You are correct, and in this case I was defining "vulnerability" as exactly what you quoted: "then the only thing that changes is the absolute amount of money you can lose". I'm thinking of the situation where we create an algorithm that we "set and forget". If we're lucky enough to have it double, triple, or multiply by tenfold our portfolio value, then as we accrue more and more money we are susceptible to being placed further and further in debt due to an errant bet on a short if we fully leverage our portfolio. I.e. the amount you can be in the hole is directly proportional to how much you intend to short. This is not really an issue for people that conduct good risk management procedures, but I can easily see the automation of a very good strategy leading to some complacency; those who are not really familiar with shorts coming into the game (like myself: I had never shorted a stock before I got here) might think that shorting poses the same risk as taking a long position. I actually thought that way before I did some of the math on risk/reward behavior of longs vs. shorts. Glad I came upon this conclusion! Thanks for the discussion points! As always, they're great. :-)
Stephen Oehler
One other thing I wanted to mention was that the implementation of trailing stops and other loss-limiting controls of that type can also lead us into a false sense of complacency. Just because we have second-by-second insight into pricing data doesn't mean our loss-limiters can actually SUCCEED in limiting our losses. This could be due to any number of reasons: 1.) Algorithm crashes 2.) Brokerage disconnects (which I hear doesn't happen often, but it does happen occasionally) 3.) Circuit breaker trips on NYSE 4.) MARGIN CALLLLLLLL!!!!! Our loss-limiters are not perfect in the least, and I had to break myself of the common thought process: eh, my algorithm will save me when things go south :-P
JP B
Agree with most things you say, but I have to say that stop-losses can be quite a good safety net. This because stop losses (not stop limit) are often placed at the moment of placing the original trade. Therefore they are active the moment you take a position. Your broker will simply keep track of the stop loss and execute it when necessary. This process eliminates most of the points you mentioned in your last comment. I'm not a big fan of stop losses myself, but theoretically speaking they are quite a good way to prevent disasters.
Stephen Oehler
Sorry, I guess I was only talking about algorithmic implementations of loss control like trailing stops by monitoring portfolio value, etc. :-)
John Radosta
Essentially yes, I agree on all points here. I'd also like to add another perspective to it.
In options trading, there are the concepts of defined risk and undefined risk.
Defined risk is when you can accurately calculate what your maximum downside exposure is on a trade (i,.e. iron condors, iron anything), undefined risk is when your downside exposure is essentially infinite (i.e selling naked calls/puts).Â
Shorting is essentially an undefined risk position. Your downside is essentially infinite* yes, but what is the trade off? The trade off is that you are given a whole other direction to play, the number of playbale positions you have at your deposal doubles. Instead of only being able to profit when things go up, you're also able to profit when things go down, and that playable option has value.Â
When would this new option of playing the donwnside be of benefit? One situation would be when the market as a whole is crashing or grinding downwards.Â
When the market is dropping, there are statistically more stocks that are going down than are going up. That is the definition of a total market downturn. Being able to short stocks in this special situation gives you access to the direction more probable than you had before.Â
Are the odds and risk profile usually against shorting? Yes, because in normal market conditions, the market is biased upwards. But there are special situations both at the market level and the individual asset level where the more favorable probabilities are skewed towards the short side.Â
Of course, the real challenge to the investor is to be able to accurately approximate that skew when it occurs, which is both an art and a science because markets can behave irrationally for a long time.
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*In reality this isn't entirely precise because your brokerage will probably automatically cover your position if your portfolio moves outside of liquidity and margin requirements, and you can calculate at want point that might happen, but in this case I'm speaking strictly on portfolio risk in isolation from external factors.
Paul Brown
There is no guarantee that a stop loss will fire and get you out of trouble. A stop loss is only a trade, and if there is nobody willing to take the other side of the trade (like in a disaster scenario), it wont be filled.
I want to know a couple of things...
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Can a short position that has blown up leave me in debt to my broker, or is my maximum liability the size of my trading account (assuming no margin)? I'm willing to risk the trading account, but im not willing to risk taking on a large debt - i can imagine a dodgy broker might manipulate a position to force me into a debt with them.
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Does this make sense?...If i believe in mean reversion, and i believe the highest probability trade is a short trade, i can exit the market and wait for the price to drop. Buy in at a lower level and wait for mean reversion. Then sell and take that profit. It's not a short, but i have profited from the high probability price drop (if there is a rebound to my market exit level). If i had stayed long throughout that move, i would be flat on profit from that down/up move.
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Derek Melchin
Hi Paul,
> Can a short position that has blown up leave me in debt to my broker, or is my maximum liability the size of my trading account (assuming no margin)?
Yes, blowing up a short position can put an account into a negative balance. The amount of margin available for a trade depends on the asset class and the brokerage fulfilling the trade. For example, if we take a short position in stock XYZ at $100 with 2x leverage, if the stock goes to $200, we'll lose 200% of our initial investment.
We recommend users ask their brokerage for further information on additional security measures they may have in place.
Best,
Derek Melchin
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Stephen Oehler
The material on this website is provided for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation or endorsement for any security or strategy, nor does it constitute an offer to provide investment advisory services by QuantConnect. In addition, the material offers no opinion with respect to the suitability of any security or specific investment. QuantConnect makes no guarantees as to the accuracy or completeness of the views expressed in the website. The views are subject to change, and may have become unreliable for various reasons, including changes in market conditions or economic circumstances. All investments involve risk, including loss of principal. You should consult with an investment professional before making any investment decisions.
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