Maintaining A Short Position


You have to understand how to maintain your short position.  If you don’t, this is what happens:


This is a Microsoft Excel 20016 spreadsheet showing what happens when you fail to adjust your short position in accordance with your P&L and how you might address that problem.  Many systems sellers on the internet claim you can just sit back and relax. You cant: if you do this is what happens to your P&L: over time it will flatline.  It should be obvious to most of us that if you maintain a simple unadjusted short your maximum gain is 100%, since a stock can not go below 0.  What is not nearly so intuitive is that if you continually rebalance your short (sell more as your equity increases, buy back as you equity decreases) you will be able to capture a great deal more of a long term decline since you are continually increasing the number of shares you are shorting as its price declines over time. Daily rebalancing is beyond most of us for a number of reasons: cost, effort and granularity being among the most important.  The small account will be unable to short 1/3rd of a share or 1/2 of a futures contract or 1/4 of a listed option.

But you need not necessarily re-balance daily to get some of the advantages reaped by such ETFs as XIV who seek to maintain a 1x exposure to short VIX futures contracts.

Your returns will differ but if you are convinced enough that a stock is going down over time, you will certainly make more by occasional rebalancing than by “short and hold”.

A classic example of long term shorting is the ticker VXX: The iPath S&P 500 VIX ETN.  By remaining constantly long of short term futures contracts, it provides a hedge for fund managers seeking to protect their equity positions. If the S&P collapses, the VIX is likely to spike as will VXX.  Many have criticised VXX but it does what it says on the tin. The “problem” is the premium sought by futures contract sellers (or indeed call option sellers) for the privilege of going long the VIX. In the futures market, contango occurs: you are buying the front month at a premium to spot and thus constantly having to renew your long position at a higher price. This leads to huge losses over time. As can be seen from a long term chart of VXX.

Here is what happened to a long term investor in VXX since its inception::

Not pretty. And thus many people over the past few years have seen an opportunity to short VXX.  As can be seen from the first illustration above, unless the short is properly adjusted, you will soon be wasting your time. The decline as a percentage of the original short eventually becomes insignificant.

As an individual, you are unlikely to wish (and unable in practical terms) to adjust your short on a daily basis. This is something that XIV does rather well (Velocity Shares Daily Inverse VIX ETN) and if you want to short the VIX this (or a similar ETN) may be your best bet as an individual.  However, many have pointed out that the (theoretical) returns from shorting VXX have outperformed XIV.

This spreadsheet contains the daily close of VXX since inception and three different P&Ls from shorting the product. (No account is taken of costs or slippage). Daily adjustment, monthly adjustment and no adjustment.

The object of the spreadsheet is merely to illustrate the fallacy of the “Short and Hold ” approach and to outline a simple and perhaps more workable alternative to daily adjustment.

Caveat emptor! Shorting the VIX is one of the most dangerous trades you will ever come across.  If you do not find a suitable way to hedge the trade you will probably be wiped out at some stage and lose your entire investment.



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