Short selling is one of the most challenging strategies in the market because, as we all know, the path of least resistance for the market is up. There is an art to it, and most short sellers have to be quite skillful to be successful.
It may not seem like it in this day and age, when we can hit a button and short an asset in seconds but, if you get caught out on the wrong side of a trade, you could end up losing a lot of money. These are lessons from the market and personal lessons, I’ve learned the hard way on what to do and what not to do when you’re shorting companies.
The Mechanics of Short Selling
When you’re shorting a company, you don’t own the shares, so you need to borrow the shares in order to sell them. At the front end, it may seem like a click of a button, but in reality you are not just borrowing these shares at a cost but you’re also having to compensate for any dividends the company pay out.
When you buy a stock, you receive dividends. When you short a stock you’re paying out those dividends with the borrowed stock. While most of us know some of the basics, here’s a step by step look at how it works:
Borrowing Shares: The investor borrows shares of a stock from a broker. This is typically done through a margin account.
Selling Borrowed Shares: Once the shares are borrowed, the investor sells them at the current market price.
Price Decline Expectation: The underlying idea is that the price of these shares will decline in the future. The investor is betting on this price drop.
Buying Shares at a Lower Price: If the price of the shares does indeed fall, the investor then buys back the same number of shares at this lower price.
Returning Shares to the Broker: After buying them back, the investor returns the shares to the broker. This process is known as "covering" the short position.
Profit or Loss: The difference between the price at which the shares were sold and the lower price at which they were bought back represents the profit or loss from the trade. If the price of the shares increases instead of decreasing, the short seller will incur a loss.
Strategic Short Selling
Strategic short selling has been made popular by big investors. They take a company and find something that seems off in their reports, fundamentals and general business operation. This is like saying a company is mispriced. This more finding something that very wrong with a company at it core and basic level, and then taking a short position against it. More often than not, it’s driven by fraudulent activities being carried out by the company. Think, Jim Chanos calling a short on Enron.
The goal for most of these short sellers is usually a very drastic reduction in share price, often to zero. One such example would be Silvergate Bank which eventually had to delist, i.e., shares kind of went to zero.
To be fair, it’s a really fun game to play and if you can get it right, you can be a big winner. But, in order to get it right, you need to do an enormous amount of work and you need to be a dog with a bone. Even then, prices may go against you if the majority of the market, don’t see what you’re seeing and that could be very painful.
The recent rise of short sellers however, has given the game a bad name. Many of these short sellers are said to employ a “short and distort” strategy, where they take a short position and then publish a report. It’s sad because they are front-running trades and I’m not sure that is entirely ethical.
Quite often these short sellers have really poor research and they find a small thread that they think they can pull to unwind the fabric of these companies. Sometimes it works and sometimes it doesn’t. I’ve read a few recently and two that caught my eye was Coca-Cola and ELF Beauty Cosmetics. The ELF report was downright terrible. But, given than consumer discretionary will see a slowdown in this environment, publishing the short could give the trade some legs. ELF has recovered nicely though from that little stunt a couple of weeks ago.
Even if you do trust the right person and the right research, holding on to a short could destroy you, particularly when we have more tactical, short-term mindsets.
I’d be sticking to tactical short selling, if you really do want to short companies. This is what we cover next.
Tactical Short Selling
Tactical short selling is done when there are temporary mismatches in an asset’s price and what we think they are worth. This is basically the shorting that all traders do. The trades are usually driven by 4 four factors or any combination of these factors: Macro, Fundamentals, Technical and Event-Driven.
Macro
The business cycle turns depending on GDP Growth, Inflation, Unemployment, Government Policy (Monetary and Fiscal). Depending on where we are in the cycle, sectors fall in and out of favor and most macro strategist employ these cycle-based strategies to take short positions. These strategies usually play out over a quarter or two.
Fundamental
When a company is overvalued based on it’s Price-to-Earnings ratio; Enterprise Value to EBITDA ratio; or simply over earnings. These strategies can take between one and four quarters to play out, sometimes longer.
Technical Analysis
This is based on charts, positioning, flows, and volatility. A great technical trader can make a lot of money shorting because they keep positions tight and take advantage of shorter-term mismatches - from one day to one month.
Event-driven
Finally, we have event-driven strategies which, as the name suggests, are driven by specific events. Some such events are:
Earnings Reports: Negative expectations from an upcoming earnings report can be a trigger.
Regulatory Changes: Changes in government regulations that could adversely affect the company.
Management Changes: Unexpected changes in key management positions.
Legal Issues: Lawsuits or legal challenges that could harm the company's reputation and financial standing.
Mergers and Acquisitions: Potential problems or disapprovals in proposed mergers or acquisitions.
Portfolio Management
With any strategy we employ, getting to the right allocation and sizing is very important. It will help you manage your risks and rewards appropriately.
Allocation
It helps to think your portfolio in terms of allocation. I know we’re not always very systematic in the way that we manage out portfolios but over time, this is something we should certainly given some consideration to. Your broker should be able to tell you how much each position in relation to your overall portfolio.
Because shorting is such a risky endeavor, I would suggest that you keep your long-short strategy at 3:1. We’re not short sellers and therefore, we shouldn't be taking unnecessary risk.
What I mean by this is that if you have a portfolio of $100. You should put $75 in long strategies and $25 in short strategies. Sometimes, given an opportunity, you may be tempted to allocate some more to a short strategy but it should never violate a 2:1 situation.
Never put more than one-third of your capital in shorts. It’s just not wise.
Sizing
Sizing follows a similar rule as well. So we have a portfolio now of $100 and we want to allocate $75 to longs and $25 to shorts. That’s one decision.
The next decision is how heavy should each position size be? If we decide that the maximum long position size should be 5%, then the maximum short position should be half of that, i.e., 2.5%. So here we follow a 2:1 rule.
What this essentially means is that no long position should be more than $3.75 and no short position should be more than $1.875.
I know this seems complicated. But, it would help if you just maintained “short positions should be half of long positions”
I know you will hear many investors saying that they’ve gone “net short”. From a portfolio perspective, trust me when I tell you this, it’s either for very, very very short periods of time, or they have a hedge that protects their position. No hedge fund goes “naked net short”. It’s just bad behavior and those that have, it’s quite likely they’ve blown themselves up.
Risk vs. Reward
Short selling comes with substantial risks.
Unlike traditional investing, where losses are limited to the initial investment, the potential losses on a short position are theoretically unlimited since there's no cap on how high a stock price can rise.
Moreover, the investor is also responsible for any dividends or rights that occur while they are short the stock.
Finally, covering shorts could be a big, big problem. We’ve all heard of the short squeeze and the various shenanigans in the market. When you need to cover, if there is a squeeze, you will be seriously out of the money. And your losses could prove to be enormous. But, this of course can be limited with the right allocation and position sizing.
This is one reason why we look at the “days to cover” or the amount of float that has already been shorted. A high short interest means that a lot of people are short and when they start to cover, it pushes the stock price higher because they are buying the stock in the market. If you’re late in covering, you could very well be caught on the wrong side of that.
Alternative Strategies
There are two alternative strategies that could be employed to take advantage of price mismatches on the short side.
Options (Puts)
If you buy a put option, you’re expecting the price to go down but the strike price at which you bought the put would be the price at which shares are delivered to you. Most people don’t exercise put options anymore to take possession of the shares.
However, the good thing about the put option is that you pay an upfront premium for the put and that’s the maximum amount you could lose. So, if the put option doesn’t play out, i.e., the price of the underlying stock goes up, your option expires worthless and you would lose only the premium.
Two things to bear in mind here:
- The price movements for a put are magnified
- Repeated losses on put option premiums do add up.
Funds employing Short Strategies
These days there are a great many Exchange Traded Funds (ETFs) that hold short positions for a mix of different strategies. These inverse ETFs then act like a regular stock. So you buy the inverse ETF if you think the prices of the stocks in the ETF will go down.
The advantage of this is you can take advantage of shorting even if your broker has restrictions and the ETF is zero bound. So if you buy at $10, that the maximum you can lose is $10, unlike with shorting where you don’t know how high the price can go.
Two things to bear in mind:
- The allocation and position sizing should be treated as a short position and not a long position even though you are buying.
- Always remember to check what’s in an ETF. Yahoo finance can give the top 10 names within the ETF.
I hope this article has been helpful. Please remember that with some basic risk management strategies, we can avoid significant losses.
Please feel free to reach out if you have any questions.