Most traders want to go both long and short because the small fluctuations in the market are tempting. Traders think “I can double my profits if I trade from both sides of the market!” This is rarely true.
It’s rarely a good idea to trade both sides of the market. Traders should stick to trading on the side of the long term trend (i.e. going long in a bull market or short in a bear market). Trading against the long term trend can be very dangerous (i.e. going short in a bull market or long in a bear market). Here’s why.
The long term trend = a bullish or bearish bias
The market has a bullish bias in a bull market. The market has a bearish bias in a bear market. This means that:
- The market goes up more often than it goes down in a bull market.
- The market goes down more often than it goes up in a bear market.
So from a pure statistical perspective, short positions have the odds stacked against them in a bull market. Likewise, long positions have the odds stacked against them in a bear market.
But here’s the more nuanced point I’d like to make:
- No matter how many historical studies you do, you don’t know when a correction will stop in a bull market.
- No matter how many historical studies you do, you don’t know when a rally will stop in a bear market.
Let’s assume you’re shorting the bull market in stocks. You expect the market to make a 6%+ correction.
What happens if the market falls -5.5% and then bounces 5% (i.e. comes close to making a new high)? Do you wait for the market to fall exactly 6%? Or do you cut your loss after the market makes a new high?
If the long term bias is strong enough (e.g. bullish investors buy the dip fierce enough in a bull market), the MINIMUM target for a counter-long term trend movement might not be met!
The opposite is also true. Let’s assume that you’re long stocks in a bear market. You expect the market to bounce 10%. What happens if the market bounces 9% and then falls 8% (i.e. comes close to making a new low)? Do you wait for the market to bounce exactly 10%?
In a bull market, corrections will often stop for no reason other than enough traders have “bought the dip”. Since large institutional investors are using corrections to “buy the dip”, you NEVER KNOW when their dip buying will be enough to put the bottom in the market. Short sellers will eventually be steamrolled by the long term bullish trend.
In a bear market, rallies will often stop for no reason other than “enough traders have sold the rally”. Since large institutional investors are using rallies to get rid of their long positions, you never know when their “sell the rally” trades will be enough to make market crash. Long traders will be steamrolled by the long term bearish trend.
Your timing is extremely important
Your timing must be deadly accurate if you trade against the long term trend. And here’s the simple reality: nobody can always time the market with perfect precision, especially traders with a short term trading time frame.
Let’s assume that you short the stock market because you expect a 6% “small correction”. Your timing needs to be deadly accurate. If the stock market first goes up another 7% and then falls 6%, you will still lose money on your short position. It’s much easier for the stock market to go up 7% than it is for the market to go down 6% in a bull market. The natural bullish bias causes this skewed probability distribution.
You cannot hold until you’re right
The beauty about trading WITH the long term trend is that your timing doesn’t have to be very accurate. If your timing is off and you lose money initially, you can always WAIT until your position is profitable.
E.g. if go long when the market falls -6% and then the market falls another -4%, you just need to wait a few weeks/months before the market will be back up (because it’s a bull market).
In other words, you can wait until you’re right if you’re trading with the long term trend.
But if you trade against the long term trend, the longer you wait the more you’re dead.
Your theoretical risk is unlimited if you short a bull market because there’s no telling how high the market can go before it makes a correction.
Countertrend indicators can be wrong
A lot of traders try to short an “overbought” market (even though it’s a bull market). A lot of traders try to go long into an “oversold” market (even though it’s a bear market).
This strategy works if the bull or bear market’s trend isn’t very strong. But all it takes is one very strong trend to wipe out the countertrend traders.
An overbought market can be even more overbought. An oversold market can be even more oversold.
I’ve seen countless traders lose a lot of money by shorting the stock market’s relentless bull market in 2013 and 2017. Every single long position that they put on was profitable, but almost every single short position was a massive loss. They would have been much better off just sticking to one side of the market (i.e. only trading on the side of the long term).
You don’t always have to be long in a bull market if you think the rally is too overextended and that a correction is imminent. But at least don’t SHORT the bull market. Stay in cash.
As you can see, every trader must first know if it’s a bull market or a bear market before trading. I don’t care how good your “trading skills” are. You will lose money on short positions in a bull market. You will lose money on long positions in a bear market. It’s better to trade from one side of the market. It’s better to trade on the long side in a bull market and the short side in a bear market.
Remember what Old Turkey from Reminisces of a Stock Operator said: “it’s a bull market ya know”.