Stock shorting strategy that actually works?

I am going to make a bold proclamation. It is nearly impossible to make money by shorting publically traded, individually listed company stocks.

The very nature of the stock market is capital formation for long-term investing. Before a stock is even listed on an exchange, the business model must pass through multiple layers of investor and regulatory scrutiny. No individual company is listed on a stock exchange with the implicit motive or mechanism that slants the field toward failure. Buy and hold investing is the name of the game.

The ETF or Exchange Trade Fund industry is also slanted towards a ‘buy and hold’ mentality. The ETF industry coos, “Don’t think for yourself, just buy a basket of stocks and hold them forever.”

For the most part, this has worked great. By simply ‘buying and holding’ a basket of random stocks, you would have achieved ample and consistently positive returns for the past 100+ years.

Just take a look at a long-term chart of the SP500 and it clearly displays a persistently upward bias. And then, of course, we have the occasional bear market or stock market crash and everyone is wondering to themselves…” that crash was so obviously going to happen!” and “I just knew the stock market was ‘overbought’ and I should have sold all my stocks.”

We have all been there.

The Federal Reserve crushes stock shorting activity

To make matters worse, whenever the stock market sells off and the economy stalls into a recession, then predictably the Federal Reserve and US Treasury devalues the currency by lowering interest rates and printing money.

Predictably, the stock market zooms higher. It’s the ultimate frustration for cash hoarders.

For the most part, shorting stocks is a fools’ errand. Some readers are probably climbing up their soap boxes and proclaiming that Jesse Livermore became the richest man on the planet when he shorted the 1929 crash. Yes, but I would also remind those same readers that Jesse Livermore also died flat broke. In fact, he shot himself in the head with a pistol, while hiding from his creditors in a broom closet.

Jesse Livermore had a suicide note unceremoniously stuffed in his underwear. The note read, “My dear Wife: Can’t help it. Things have been bad with me. I am tired of fighting. Can’t carry on any longer. This is the only way out. I am unworthy of your love. I am a failure. I am truly sorry, but this is the only way out for me.”

In short, the act of successfully ‘shorting’ individually listed companies over the longterm has been a nearly impossible feat.

With that being said, we are going to explore a fully automated, stock shorting strategy. The strategy is listed in Larry Connors excellent book:

Buy the Fear, Sell the Greed: 7 Behavioral Quant Strategies for Traders

Why even bother?

Many readers are probably asking themselves that if stock shorting is nearly impossible to achieve long-term success, then why even bother exploring the topic?

Well, the truth is that its 2018 and we are 10+ years into the current bull market. A typical bull market is 7-10 years. We are also in the midst of a Federal Reserve cycle where interest rates are heading higher.

In other words, the nearly perfect conditions exist for a shitty stock market. The time to be a buyer of stocks was 10 years ago. The time to be a seller of stocks is right now. Currently, everything feels and looks nice and rosy. Unemployment is at an all-time low. Small investor sentiment is at an all-time high. Stocks just keep churning higher and higher and higher.

Everything is just wonderful (Trump said so). Until it is not. The following strategy and rules are meant to take advantage of investors that are piling into stocks with wanton abandon.

We are looking for lemmings. We want to help the lemmings over the cliff.

The Rules and Conditions

The following rules for this shorting strategy are pulled directly from Larry Connors book, and defined as follows:

1) 20-day moving average of Volume is greater than 1,000,000 shares traded daily. In other words, we don’t want thinly traded stocks that can be easily manipulated. We want a deep market with plenty of people actively involved.

2) The price of the stock must be over $5 per share. Anything less than $5 should be considered a low quality ‘penny stock’ with little investor interest. Again, we want stocks where average investors are willing to pay higher prices because they perceive higher value. No penny stocks that are easy to manipulate.

3) The 21-day Historical Volatility is greater than 1 (100%). In other words, we are focusing only on the WILDEST stocks. Not the slow-moving utility stocks. We want the company that is primarily engaged in harvesting bananas suddenly proclaim that they solved erectile dysfunction with their ‘banana boner pill.’

4) The Connors RSI closes above 90. The Connors RSI is just a 3-period RSI, don’t let the ‘Connors’ part fool you into believing its somehow magical or better than the regular RSI. It’s not. But Larry plugs his magical indicator, which is OK. Testing on the regular RSI works just as well.

If all of these conditions exist…then we are looking to SHORT the stock, the following day.

The Short entry

If the stock has met all of the above conditions, we are looking to short the stock at the opening price + 3%.

In other words, we want the market to open and then push higher by 3%. Once the market has pushed 3% higher, intraday. Then we short the stock.

In Larry’s book, he does not use stops. However, every time I publish a strategy with no stops, then the peanut gallery goes nuts and starts decrying that no stop is being used. Ok, fine. I have included a $500 stop for each short trade.

Since we are trading stocks, and since most of my readers have very small trading accounts, then the average trade size will be $2000 per position. In other words, if the stock is $10 per share, then the position will be 200 shares.

The EXIT

The exit is simple enough. The book describes that a short should be closed once the Connors RSI crosses below 30.

Once again, you can use either the Connors RSI or a 3-period RSI. The testing is nearly identical. Since most of my readers are not programmers, then I recommend keeping it simple and just use the 3-period RSI.

How to find potential setups

Since this strategy has the potential of trading any stock in the entire stock market, and there are currently over 8000 listed stocks, then you will need a scanner. Nobody can individually check 8000 stocks each day.

I use TradeNavigator. It alerts me to any new setups, at the end of each trading day.

You can use whatever scanner you like. But remember, you need the following:

  1. 20-day moving average of volume > 1 million shares
  2. Stock price > $5 per share
  3. 21-day historical volatility > 1 (100%)
  4. 3-day RSI > 90

Sell the following day at Open + 3%.

Use a $500 stop.

Exit when the 3-day RSI closes below 30.

What results can I expect?

The following test is from 2006 to present. I have tested the strategy over every publicly traded stock in the entire US stock market. Results as follows:

Connors RSI Short Strategy

With a sample size of over 700 trades, notice the average trade of $62. This is really incredible considering how slanted the table is against short sellers.

Many novice traders are probably climbing up their soapboxes and screaming about the potential $12k drawdown. However, this drawdown needs to be taken into context when you consider that we are talking about a portfolio of over 8,000 potential symbols.

The proper way to analyze the potential drawdown of a portfolio trading strategy is through something called Monte Carlo Analysis.

Using Monte Carlo Analysis, we can model nearly all of the potential outcomes which gives us a risk distribution. Using a Monte Carlo Anlysis on the above strategy, with 2000 simulations, we can reasonably predict the following drawdown for this strategy…

ConnorsRSIShortStrategyMonteCarlo

The Monte Carlo analysis might seem foreign to some readers, but the analysis reveals that we can reasonably expect a $3,900 profit every year. Conversely, we can reasonably expect an account drawdown of $3,900 to occur once every 10 years.

This is the type of balance of risk vs reward that I want to see. Once again, for a short trading strategy, these numbers are quite remarkable.

The ‘secret sauce’

When I look at a trading strategy, I ask myself a very simple question–what is the logic of this? Why is this strategy working? What human tendency does this exploit?

Some readers might be lured into believing that the logic is somehow hidden within the settings of the RSI indicator. It is not. The short-term RSI is a just a useful tool that does an OK job measuring price movements. It is no more predictive than any other magical trading indicator.

Some readers might also be lured into believing that Historical Volatility is also something magical to solve their money problems. It is not. The Historical Volatility indicator simply measures how far and fast prices tend to move away from their mean value.

So what is the ‘secret sauce?’ In my opinion, what makes this strategy special is that it focuses on higher quality stocks, with higher prices, and deep public interest. Greedy buyers pile in at any cost. We are looking for just those extremely rare moments buyers rush in, and then quickly lose steam.

This model does not happen very frequently. Testing shows that a company might exhibit this wild behavior once or twice during its entire lifetime.

The key to taking advantage and finding these rare trades is to use advanced scanning tools. I cannot be done by hand.

Wrapping things up

Thanks for reading. Geez, I promised myself that I would keep this blog post to 800 words. Now it’s over 1700 words and it took a couple of days to write. I apologize for taking so much of your time!

For my programmer friends out there…I will give you a few hints:

  • Much, much better performance if you drop the stop loss or widen.
  • You can change the Historical Volatility settings to .6 (60%) and still get excellent results with a lot more potential setups.
  • Consider scaling 50% entry on day one and 50% on day two.
  • Dump half your position on the RSI < 30 and the other half at RSI < 10. Crazy good results.

For my non-programmer friends, if several people request a daily update to this system, then please leave a comment below. I will start live tracking and posting the daily results for this strategy on a separate webpage.

-Emmett

 

 

3 Comments

  1. James October 1, 2018
    • Emmett Moore October 1, 2018
  2. scottieee September 25, 2018

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.