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Trade any market environment – how short selling opens new opportunities

Chris Weston
Head of Research
Feb 27, 2023
When risk aversion hits financial markets, investors will typically look to manage drawdown with short-term hedging strategies – often buying puts, selling index futures or sophisticated strategies that harness higher volatility.

Some investment firms will outsource capital and diversify at a strategy level – for example, there has been increased investment in trend-following managers (CTA’s) - given trend-following historically has uncorrelated returns to traditional 60/40 portfolios, and typically outperforms in times of market stress, as we saw in 2022.

Traders also manage drawdown in a position (or portfolio), often acting quickly to cut losses, sharing in the belief that managing risk is the cornerstone of any robust trading process. At its heart traders define risk through the distance to their stop loss and position size. And, for those who use leverage, the amount of margin placed on each trade is key and should be fitting to the volatility in the market.

Traders should have an open mind and remove all ego 

Where traders can greatly differ from investors is the ability to be more active and opportunistic. To be nimble and agile in their approach and trade markets whether price is rising, falling or even range bound – they can alternate strategies, and even timeframe, and attempt to capitalise from any market environment.

To do this successfully adopting a systematic approach can be advantageous, however, should one choose to trade with a discretionary approach, an open mind is essential – knowing when to hold and when to fold without ego keeps a trader in the game – they’re slaves to the price action and are humble to the fact the market is bigger than one mere soul.

Remember bulls and bears make money, and traders react to flows and the rhythm and pulse of the market.

Short selling offers share CFD traders increased opportunity

While traders are comfortable taking long and short positions in commodities, FX, and equity indices (such as the NAS100, HK50 or GER40), the ability to trade a two-way price (i.e. long and short) in single stocks (such as Tesla, Apple, or Netflix) increases the ease by which traders can be opportunistic across a wide range of international equities.

Tesla daily chart – how traders can gain advantages from being able to trade long and short.

Preview

Being able to trade long and short enhances and increases the flexibility across trading strategies regardless of timeframe – for CFD traders, having the choice to initiate short positions in equity CFDs radically increases the number of instruments that could be trending or exuding big momentum shifts – this, of course, offers increased opportunity to trade their strategy; be it mean reversion, trend-following, mean reversion, macro discretionary or long/short (relative value).

Alternatively, for equity investors (who don’t use leverage), the ability to short sell share CFDs offer a low-cost hedge for single stocks or a broader portfolio.

Traders manage and price risk 

When risk aversion truly strikes correlations across asset classes rise and markets move as one, just with a different ‘beta’. The fundamental driver of risk aversion absolutely matters, predominantly, because at the heart of the concerns is how market participants price risk.

If there is increased uncertainty and low confidence that a circuit breaker or a positive catalyst is upon us, having low confidence in deriving an accurate valuation for an asset, especially when there is a high rate of change, can keep the buyers away, which, in turn, can lead to a prolonged drawdown.

It’s this lack of visibility and low confidence to price risk in an instrument/market where orderbook dynamics and flow play such an important role in the duration and severity of the drawdown.

When the buyers step aside the sellers often have a far easier time pushing prices lower – essentially, this ‘buyers strike’, amid higher volatility, is a golden backdrop for short sellers and those positioned for lower prices in risky assets (e.g. equity).

It's here where price trends develop and where weakness breeds further weakness, as trend-following funds (also known as CTA’s) and volatility-dynamic hedge funds look to increase short positioning as the bearish trend builds.

Often options dealers will have sold puts to clients and as the underlying market trades ‘in-the-money’, dealers must dynamically hedge their exposure and that will result in the dealer shorting the underlying equity (or index future) – again, dealer hedging flow can exacerbate drawdown, often resulting in rapid moves and pronounced range expansion.

Understand the characteristics of trading long or short 

The characteristic of market drawdown is important – this is especially true for single stock equities and equity indices, where we often see aggressive, but short-lived selloffs, followed by a positive longer-duration ‘grind’ type price action – as the saying goes ‘up the stairs, down the elevator’.

This historical difference in price action (between declining and rising markets) can be partly explained by the range of market participants. Notable, money managers with a long-only mandate hold incredible levels of capital and will compel short sellers to rapidly cover their position when talk of ‘value’ emerges, and confidence returns – this can result in violent bear market rallies.

Also consider the impact that corporate buybacks have, where in the past two years we have seen that the biggest buyers of equity are the companies buying their own stock – this causes a suppression in volatility and supports equity prices.

Central bank actions and the impact on short selling 

Through the years of central bank liquidity and asset purchases (i.e. Quantitative Easing), short selling, notably in single stock equities and even equity index futures, offered a low probability outcome. Pullbacks were shallow as traders ‘bought the dip’ and investors were forced to take risk, while hedges often led to a drag on the fund’s performance.

Lower central bank liquidity and higher interest rates increase shorting opportunity

Times have clearly changed with the market being treated to the fastest pace of interest rate hikes in history, while multiple central banks have aggressively reduced their balance sheet. Cash-like products, such as US 6-month and 1-year Treasury bonds now yield 5% and this offer investor new opportunities to get paid to play defence. It also means risky assets must have far higher expected returns than cash to really appeal. Again, this can increase volatility.

The risk of renewed drawdown remains high, and traders are having to be open-minded like never before – market movement often makes little fundamental sense and as we try and attach reasoning to movement, traders go about their business reacting to what price is doing – this is a trader’s market and will likely remain so for some time.

Having the access to two-way pricing, to capture any market condition, with a wide product range and advanced risk management tools, offers an edge for traders in this macro backdrop.

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