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Long vs Short trades

Perhaps because we offer several long-only systems we have often been asked if there is a difference in trading the long side of a market vs. trading the short side. I think most experienced futures traders would quickly agree that there are inherent differences between trading long versus trading short. These differences might be well worth considering when developing the logic for a trading system. Listed below are just a few of the many differences that I have observed over many years of trading. Please keep in mind that these differences are simply my personal observations and not the result of any academic study.

1. Uptrends generally tend to be longer in duration than downtrends. Specifically, many technicians have observed that a typical uptrend seems to last about twice as long as a typical downtrend. We can only theorize about logical explanations of why this might be the case. Perhaps the most significant reason for the persistence of uptrends is that on a long-term historical basis we have been doing the majority of our trading in an inflationary environment. It is true that the rate of inflation has been reduced over recent years thanks to Federal Reserve monetary policies that presume that any inflation is bad but, in spite of the Fed.’s best efforts, inflation still persists. The debate, if any, is merely over the current rate. Even though we now have less inflation rather than more inflation, over any extended period of time it would be a safe bet that prices are likely to be higher rather than lower. There will always be occasional periods of declining prices but the lows will probably be getting steadily higher over the long run.

2. Uptrends generally tend to be more orderly and less volatile than downtrends. We would surmise that this orderliness is because traders are typically more comfortable and optimistic when trading the long side of a market. The public’s preference for the long side isn’t as illogical as it may seem at first glance. After all, the price of a physical commodity can rise almost infinitely while the price on the down side is obviously limited at something above zero. I can remember stories many years ago about the onion futures market where prices actually appeared to be going to zero. Eventually someone figured out that the price was so cheap that they could take delivery of the onions and then throw them away in order to sell the empty bags at a profit. Short side profits in the physical commodity markets are definitely limited even though they may be very substantial at times. However, because the profits on the long side appear to have unlimited potential, long-side traders are more likely than short-side traders to employ pyramiding strategies that use open profits to fund more buying. Contrary to what most of us were taught in Economics 101; rising prices serve to increase demand and perpetuate the existing uptrend. On the other hand, because short side profits are limited, pyramiding as prices decline would be less attractive.

3. Uptrends tend to end in spikes with high volatility while downtrends tend to end in flat areas with low volatility. Because there is no limit to how far prices can become extended on the upside and the previously mentioned pyramided positions can become very large, there are likely to be huge long liquidations once prices have peaked. On the downside positions are seldom pyramided and the taking of limited profits is done more steadily throughout the decline. As a result there are rarely huge positions remaining to be liquidated as the market reaches bottom. Bull markets tend to attract traders and the liquidity increases as the prices rise. On the down side the low prices and lack of volatility tend to make traders look for rising markets with more opportunity and more liquidity.

Keep in mind that these are very general observations relating specifically to physical (non-financial) futures markets and the same logic does not necessarily apply to securities or financial markets. For example if you go long in Yen futures you are also short dollars and if you go long in Eurodollar interest rates you know that if they go up to 100 it means that interest rates are at zero. However many financial markets, like the stock indexes, do have an obvious upside bias.

Once we have a general idea of some of the basic difference between rising and falling markets we need to use that knowledge to improve the design of our trading systems. Here are a few of the accommodations to market direction that purchasers of our systems may have observed.

1. We sometimes design systems that trade only from the long side. Because we are using a multiple systems approach we don’t need every system to trade in both directions. The long side is usually easier and more profitable. In fact, who says the short side is necessary at all? As long as our long-only system stays out of trouble when prices are declining (easily done) we can wait for the uptrends. There are plenty of markets to trade; why not trade the easy ones.

2. When designing a system that trades in both directions we sometimes make our long-side entries easier to trigger which results in more long trades than shorts. We are intentionally building in a long side bias. Many traders will not agree with this built-in bias but we think it makes sense because we have many good reasons to prefer the long side.

3. When designing exit strategies in a system that trades in both directions we often let profits run further on the long side. Since we expect the short side profits to be limited we are quicker to take a profit once our short position has adequately rewarded us for the risk we took. On the long side we prefer to try and let the profits run. Systems do not have to be symmetrical (same parameters long and short) and it can be logical to have different rules and parameters for the short side.

4. There may be price levels where it does not make sense to go short. For example, sugar has traded as high as 63 cents per pound and as low as about 1.5 cents per pound. Would we really want to go short at 2 cents per pound? The risk is obviously much greater than the potential reward. Minimum price levels for shorting can easily be built into any system.

In addition to the technical observations we have passed along there are also fundamental (supply/demand) considerations that influence the trading characteristics of longs and shorts. Perhaps we will discuss these fundamental issues in another Bulletin.

In summary we think there is a good case for treating the long side of markets differently than the short side. Entries and exits do not have to be symmetrical and we do not have to trade both long and short. I obviously favor the long side but I know traders who specialize in trading only the short side because they believe the moves on the downside produced quicker profits. Although these traders disagree on which side is best, they agree that the characteristics are different. We would be interested in hearing your views and observations about trading long and short. Post your comments right here in the Forum.

Good Luck and good Trading
Chuck

Reprinted with permission by Chuck LeBeau at www.traderclub.com