Sunday, April 27, 2008

How Good Do You Have to Be to Make Money by Shorting?

I was reading this interesting paper on returns to option strategies (heavy econ paper) and was thinking about how good a trader needs to be to make money from shorting stocks. The expected return in the long run from buying stocks is something like 10%. Therefore, the expected return from shorting stocks is -10%. In order to make any money at all from shorting - i.e. beat a checking account - you need to have an alpha - an average excess return - of 10%! To beat the market by shorting you need to have an alpha of 20%! I raised a lot of skepticism when I suggested that my alpha was 9%. Buying puts has similar implications. Selling puts is, however, on average, a money-making strategy. The paper finds that buying puts loses money even more effectively than shorting stocks. The problem with selling puts is the risk of a crash - you need to have some very good risk control in place. Selling puts also is psychologically difficult -the downside maximum loss is potentially very large and uncertain with a limited and known upside, even though the mean return is positive.

By the way selling calls is also a losing strategy - selling covered calls doesn't "add income" - it reduces expected returns.

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