Boost Short-sellings with Reinvestment
Robert Sampy
www.tradedit.net

1. Lever Effect / Short-Sellings
Any short-selling has a lever effect against the trader : if the stock looses n% in a day, the trade will gain less than n%. The performance of the trade will be smaller because it is calculated on the price at the opening of the trade. The lever is egal to "Stock's Last Quote" / "Trade's Entry Quote".

Let's have a simple example : 3 months ago, Paul sold XYZ stock for $100. Yesterday, the quote was $40 when XYZ lost 10% to reach $36. What a good trade :o). So, Paul wins $4 for each stock initially sold $100. His trade's performance gains 4% versus 10% for XYZ, and the lever is 0.4...

The trade has already lost its power and become blunt. And this situation can only grow worst because the more XYZ will go down, the more the erosion of the trade will be important (remember that lever is "Stock's Last Quote" / "Trade's Entry Quote").

2. Reinvestment Strategy / Lever Effect
In order to reduce this erosion, Paul needs a trade substitution strategy. In other words, he needs a list of actions that replaces the trade (same asset, same entry and exit quotes) and increases the performance.

The reinvestment strategy satisfies to all these requirements. Moreover, it is an easy to apply strategy : all Paul has to do is to cut the trade into several "sub-trades". Because the initial trade is too long and has lost its dynamism, it is replaced by several trades that are short (a good idea for short-sellings ;o) and percussive. Of course, the commissions will grow, but they will be quickly compensated by the trade reinforcing.

Let's return to Paul : he closed his trade when XYZ reached $36 and won 64% (commissions not included). His friend John invested $1000 on the same trade using reinvestment strategy : he sold XYZ for $100 and bought them back $80, then sold XYZ again for $80 and bought them back $60 and eventually sold XYZ for $60 to buy them back $36. How much did he won ?

3. Gain Increase / Reinvestment Strategy
Trade 1 : The initial asset is $1000, so John sells 10 stocks.
Later, he buys them $80. His benefit is 10 * 20 = $200.
His asset is 1000 + 200 = $1200.

Trade 2 : John sells 1200 / 80 = 15 stocks quoting $80.
He buys them back $60 and his benefit is 15 * 20 = $300.
His asset is 1200 + 300 = $1500.

Trade 3 : John sells 1500 / 60 = 25 stocks quoting $60.
He buys them back $36 and his benefit is 25 * 24 = $600.
His final asset is 1500 + 600 = $2100.

Eventually, John realized a 110% performance versus 64% for Paul.
The trade has been boosted and the gain factor is 1.7 (110 / 64).
But, despite this good result, Paul cannot decide whether the
strategy is good or not : he has to examine the risks first.

4. Risk Increase / Gain Increase
What will happen if trade 3 fails ?
John sold 25 stocks for $60 each. Unfortunatly for him, the bearish period is over and XYZ climbs to $70 (-16.7%) where John's stoploss is executed. So, the loss on this trade is 25 * 10 = $250. His final asset becomes 1500 - 250 = $1250. John's global performance is +25% versus +30% for Paul (sold $100 and bought $70). The performance has been divided by 1.2 (30 / 25).

5. Conclusion
In short, when the expected scenario occurs, the gain increase ratio is 1.7 and when it fails, the gain decrease ratio is 1.2. And so, the strategy is gainful.

Try to use it for your next short-sellings and you will be surprised. The only extra work is to prepare a trade-sheet with your sub-trades quotes and assets in advance. A very small amount of extra work for great benefits ;o)

The reinvestment strategy is easy to apply within several trading methods : trading on pullback, trading on Elliot waves...

Robert Sampy is the author of TradEdit,
the acclaimed trading methods analysis software available on http://www.tradedit.net