StockRanks | NASPS - A Short Twist On NAPS

7th Jun '18 by Merlotman

10 comments 5431 reads

Working on Stockopedia's theory that a basket of shares with the highest QVM rankings will on average outperform the market I decided to see whether the opposite was true - whether a basket of shares with the lowest QVM would underperform. Indeed what i was hoping was that not only would they underperform but on average exhibit negative returns over a 12 month period. If this were the case going short on this basket (via spread bets) would generate a positive return. I had from time to time gone short on individual shares but it was the usual story – I picked the right candidates but the timing was often wrong and I would get stopped out. Hence I decided to try a portfolio approach of what I am referring to (hope this is OK Ed) as the NASPS portfolio (the extra S is of course for Short).

As well as potentially making a return in a market which may go sideways over the next 12-18 months, I hoped that it will also provide some protection for my long portfolio against any general market correction. I thought I would share my experience of setting up the portfolio and I will follow up in 6 months with a review.

So how did I select the portfolio and what is my approach to risk management?

The selection approach adopted was to a great extent the one of blissful ignorance that Ed adopts when he puts the NAPS portfolio together. I screened on the basis of QM below 30, high debt and relatively low spreads. However because I really wanted the lowest QVM picks I didnt diversify across industry. This I felt was justified because my losers would come through company specific issues (e.g. an exploration company hitting a gusher) rather than say industry factors (e.g the price of oil).

The biggest problem, as you would have guessed, was that less than a third of suitable candidates can be shorted mainly because there was no stock available for borrowing. I managed by tweaking the criteria a bit to come out with 16 UK stocks to which I added Tesla and a short on the Italian market to cover the current political uncertainty.

As it is a short portfolio stops are a must. I set these at a generous level to give the…

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Timmytrump

7th Jun '18

Very interesting!

But only for capital you don't mind losing!

cig

8th Jun '18

One way to short low stock ranks in a "farming" approach while avoiding idiosyncratic short risks and unavailable stocks is to short an index or ETF and long say the top 1/2 or 2/3 of the holdings by stock rank with the same weights, which results in a net short of the complement.

Unfortunately, few spread betting providers offer small cap ETFs or indices.

Mechanical Bull

I do something similar, namely shorting a selection of Stockopedia “losing” styles. However, there are a couple of important differences.

First, I use CFDs as I find it easier to understand and track my trading costs. Of course, CFDs also involve borrowing costs, and given that a NAPs strategy involves holding for a year, this is not insignificant. With my IG account, this works out to about 4-5% a year, which will put a significant dent in profits if you are aiming to hold for a whole year.

The second thing is that I use tight stops. My rationale is that shorting is mathematically inferior to going long and so you need tight stops to get a decent risk/reward payoff. For example, if you picked Games Workshop for a NAPs long portfolio at the beginning of 2017, you would have got a massive 300% gain by the end of the year. It is mathematically impossible to get a similar gain by going short. Since you cannot get a very large pay-off, you want to try to minimise your risk as much as possible.

I started off using 10% stop losses but then moved to 7-8% and I am now experimenting with going even tighter at around 5%. Of course, I will get stopped out more often, but then the price doesn’t have to drop as far for the reward to exceed the risk I am taking. I have not really investigated this, but maybe it is less feasible to have such tight stops with a spread-betting account.

I believe that this kind of shorting strategy is more suited to the shorter term (i.e. holding for a couple of weeks up to a few months) with more of a trading mindset. Since you are borrowing, you want to look for stocks that are likely to move down quickly, which in turn means that you need to pay more attention to the price action.

If you get big move down quickly you want start thinking about taking profits because the risk/reward equation fundamentally changes. Let’s say you short something and the share price quickly falls 50%. It is possible that the share price could keep dropping, but your profit margin will decline. For example, a further 50% decline will only give a half the profit of the first 50% drop. With borrowing costs and the possibility of a rebound you may be better off taking profits. In summary, the mantra of “running your winners” (or should that be losers?) is much less applicable when shorting.

For these reasons it is not clear to me that a buy and hold NASPs type approach is the way to go. I am not saying it can’t be profitable, but it is probably quite marginal.

Gromley

Interesting Merlotman - thanks for sharing.

I embarked on a similar exercise at the start of the year, but family crises prevented me from doing a proper write up, so I'm planning to write it up with a half year review in July. It will be interesting to compare notes.

Also interesting to read mech bull's comment.
I think it very much depends on what you are looking to get out of it, but from my perspective I don't agree on either tight stops or short holding times. Whether the profitability is marginal or not, time will tell, but my primary objective at the outset was to establish an effective hedge that doesn't cost the earth (if it actually generates a positive return, that is to some extent a nice bonus!)

Hi Gromley

I agree that if you are prepared to treat NASPS as insurance to smooth out your returns and hedge against a major correction then maybe this is a viable strategy. However, the mathematics of shorting point to it being a less attractive proposition than NAPs and if you are diverting capital into it then your overall long-term returns will be lower.

Also, shorting is inherently more risky. There is a non-neglible risk that that low ranked oiler that you shorted hits a gusher. This could lead to a big gap up that goes way past your stop-loss. Theoretically, you could end up losing even more than your initial position. Personally, I am not willing to take this kind of risk for a strategy that is only marginally profitable.

There is one other issue with buy and hold shorting......dividends!

With CFD shorts these get taken out of your account. With spreadbets I am less certainly but I believe these are factored into the spread. Obviously, this is going to be more of an issue the longer you hold.

MB

Hi MB

For spreadbets Dividends used to be included in the quoted price / spread by now (at least on the accounts I have) they are treated as cash transactions - which imho makes it easier to understand and plan for - the cash transaction happens on the XD date, so all things being equal (which of course is never exactly the case) as the SP movement should reflect the dividend.

Anyway I'm only too happy to stress the point that there are serious inherent risks in any approach involving shorting (and/or leverage) that need to be given very careful consideration and planning. (I'm increasingly of the view though that similar cautions apply to plain vanilla longs)

I'll probably tackle these themes more fully when I write up my experiment,

But just on the subject of stops, I think it is worth remembering that I (& I think merlotman) are talking about diversified portfolios, whereby you have some insulation against 'rogue events' simply from position sizing. When looking at stops (and this is so far by no-means a comprehensive study) as a portfolio like this I've so far found it nigh on impossible to find a level where being stopped out performs better than riding the spikes (and more often than not see the price settle back).

Clearly though, you do need to protect yourself against being short a multi-bagger so some level of protection is clearly in order. With SBs on some stocks you can set a guaranteed stop loss (for a small premium) and if for example (not a recommendation) you set a guaranteed stop loss at a 100% rise, you have the same worst case exposure on your short portfolio as you do in the event of one of your longs going bust.

Anyway as I say there are lots of considerations one needs to take into account before venturing too far down this path.

Caveat venditor.

Merlotman

Thanks for all the comments
Just to confirm that on my account at least divis are Debited on ex div date. In addition cost of borrow is currently circa 2% annualised
Agree that This should be viewed more as a hedge than an investment strategy. I have used index shorts and options in the past but have found them to be an expensive hedge hence this experiment. MB Your comments on stop distance are relevant to the extent they reflect investment style. I don't necessarily have a trading mentality so have to set them wider and have spread the risk amongst a number of names as Gromley suggests.
Gromley look forward to your write up
Have a great weekend

13th Jun '18

For a concentrated portfolio you can cap your loss to your initial position by using a different broker for every position (each account with a single short position), which combined with the new regulatory negative balance protection for retail investors in CFDs achieves the same as guaranteed stop losses, without any explicit extra charge. Bit of a hassle though.

ISAallowance

That's a nice idea, but not sure that it would work exactly like that in practice - I think the new ESMA rules include position close out once account equity is below 50% margin requirement, so your "stop" would then be somewhere unpredictable somewhere between 50% and 100% of initial account funding.

All IMHO - have never had a margin call in real life yet, touch wood (and I hardly ever short).

NASPS - a short twist on NAPS

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Merlotman

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