The best way to short?

[frommi]

While thinking about the short context, i thought about shorting and what is the best way to do it.

Looking at some stocks like DDD or TWTR i thought that the mispricings on the upper side are a lot greater than on the lower end of the spectrum in the current market. So how is the best way to profit from that?

 

For example for DDD (current price 92.5):

 

- Sell 95$ Calls

    pros: get 20% if the stock stays below 95, get money upfront

    cons: unlimited downside

- Buy 90$ Puts

    pros: limited downside, upside around 200% when the stock is halfed

    cons: high premiun, cost of leverage > 20%

- Naked short selling:

    pros: get money upfront, don`t have to worry about options, can put that money to work in undervalued stocks?

    cons: unlimited downside, if short selling is banned you can loose your shirt

- Sell Calls, buy puts with the money?

    isn`t it the same as naked short selling?

 

Is hedging the portfolio that way a good idea, and if yes how would you do it? (I thought about hedging with gold/bonds, but they are too expensive for that at the moment for me.)

[constructive]

short selling != naked short selling

 

http://en.wikipedia.org/wiki/Naked_short_selling

[ItsAValueTrap]

The best way to short is to buy puts.

 

If you short common stock, there are multiple ways that you can lose money even if you're right.

[Hielko]

I don't think there is a single correct answer. There are may ways to go short, and what the best option is depends on how hard it is to borrow shares, what the risk is of a short squeeze, what your timeframe is, what your brokers margin requirements are for various options, how much liquidity you need and what's also not unimportant is what your view is on how the thesis will play out (big difference between an overvalued large cap that you think will simply underperform the next few years versus a fraud that might get halted tomorrow).

[jschembs]

I don't think there is a single correct answer. There are may ways to go short, and what the best option is depends on how hard it is to borrow shares, what the risk is of a short squeeze, what your timeframe is, what your brokers margin requirements are for various options, how much liquidity you need, what also not important on what your view is of how the thesis will play out (big difference between an overvalued large cap that you think will simply underperform the next few years versus a fraud that might get halted tomorrow).

 

Great summary. Buying puts may seem like the better alternative, but you must be right on both magnitude and timing in a way that outright shorting doesn't require.

[netnet]

Remember Keynes's quote while shorting: Markets can remain irrational longer than you can remain solvent!

 

This problem applies both to puts and shorting.

 

Unmentioned in the discussion so far is a paired trade either with a derivative or stock.  In the former, you could sell a lower strike call and buy the high strike call for "protection".  In the latter you could buy the strongest company in the industry and short the fraud, so a rising tide doesn't kill you.  One of the better  trades all things being equal, is to have a derivative cap your downside and potentially lessen your margin.  So buy a warrant or a call and short the common.

[bz1516]

I've had good luck shorting deep ITM calls.  Otherwise I usually just short the common for liquidity and transaction costs purposes.

 

Have had poor luck with pair trades and don't do them anymore.  The problem with them is you have to be right on two stocks and the odds increase sharply that something will go wrong with the trade when there are two names involved.

 

To me the most important thing about shorting is the kind of situation you short.  I usually only short stocks I know as well as the industry analysts which are usually small caps or stocks I identify as civil frauds.  I like civil frauds because the managements are constrained by a set of rules to keep themselves out of jail.  I want the stock to be fundamentally obviously flawed in one way or another.  that's the commonality of the two categories.  RVLT and LYSDY are my two favorites right now.  I avoid the large caps.  I don't see what kind of edge I could have playing against armies of Ivy League B school grads that follow those companies.

[ItsAValueTrap]

I've had good luck shorting deep ITM calls.  Otherwise I usually just short the common for liquidity and transaction costs purposes.

 

Have had poor luck with pair trades and don't do them anymore.  The problem with them is you have to be right on two stocks and the odds increase sharply that something will go wrong with the trade when there are two names involved.

 

To me the most important thing about shorting is the kind of situation you short.  I usually only short stocks I know as well as the industry analysts which are usually small caps or stocks I identify as civil frauds.  I like civil frauds because the managements are constrained by a set of rules to keep themselves out of jail.  I want the stock to be fundamentally obviously flawed in one way or another.  that's the commonality of the two categories.  RVLT and LYSDY are my two favorites right now.  I avoid the large caps.  I don't see what kind of edge I could have playing against armies of Ivy League B school grads that follow those companies.

 

What do you do about the borrow on RVLT?  I shorted it briefly and quickly covered; the borrow seems crazy expensive and the chance of buy-ins might be high.  (I use Interactive Brokers.)

 

The problem with selling calls is that you are still somewhat exposed to the cost of the borrow.  If the stock goes up and the borrow gets expensive, the counterparty may exercise their call early to collect the borrow.  This happened with Tesla.

 

I'm obsessed with short selling but almost every trade looks crowded right now.

 

2- I've written about the dangers of short selling common stock here:  http://wp.me/p1mOGr-y8

[Hielko]

Yeah, I think it's important that you aren't short a crowded trade. The shorts are almost always right that the company is indeed overvalued, but when you pay a very high borrow fee and face other risks such as a squeeze or a buy-in it's hard to make money. I look at the borrowing costs to see if the trade is too crowded or not. Borrowing CRM is very cheap with a 0.17% rate at IB, so it's not a crowded trade. VEEV and TXTR are a bit more crowded with a 1.24% and 2.30% rate; but that's imo still manageable (I'm short all three names). Given how large these names are I'm not too worried that the borrow will be an issue. If I would be I could (and would probably) lock in the low borrow rate by buying puts or using some other type of derivative to create a short position. Downside is that these instruments often have low liquidity and high trading costs, so it's expensive if you want to be able to change your mind about a position.

[jschembs]

I'm surprised CRM is as easy and cheap to short as it is. I suppose that's largely because of its overwhelming institutional ownership.

 

Now if it would just become a profitable short.

[LC]

The best way to short is to buy puts.

 

If you short common stock, there are multiple ways that you can lose money even if you're right.

Same with puts...you need to be right about timing, and premium paid.

[bz1516]

I've had good luck shorting deep ITM calls.  Otherwise I usually just short the common for liquidity and transaction costs purposes.

 

Have had poor luck with pair trades and don't do them anymore.  The problem with them is you have to be right on two stocks and the odds increase sharply that something will go wrong with the trade when there are two names involved.

 

To me the most important thing about shorting is the kind of situation you short.  I usually only short stocks I know as well as the industry analysts which are usually small caps or stocks I identify as civil frauds.  I like civil frauds because the managements are constrained by a set of rules to keep themselves out of jail.  I want the stock to be fundamentally obviously flawed in one way or another.  that's the commonality of the two categories.  RVLT and LYSDY are my two favorites right now.  I avoid the large caps.  I don't see what kind of edge I could have playing against armies of Ivy League B school grads that follow those companies.

 

What do you do about the borrow on RVLT?  I shorted it briefly and quickly covered; the borrow seems crazy expensive and the chance of buy-ins might be high.  (I use Interactive Brokers.)

 

The problem with selling calls is that you are still somewhat exposed to the cost of the borrow.  If the stock goes up and the borrow gets expensive, the counterparty may exercise their call early to collect the borrow.  This happened with Tesla.

 

I'm obsessed with short selling but almost every trade looks crowded right now.

 

2- I've written about the dangers of short selling common stock here:  http://wp.me/p1mOGr-y8

 

 

Nice article on your blog valuetrap!

 

Last I looked the borrow at IB was ~30%.  Thats high but there are two mitigating factors.  I plan my shorts around events like quarterly reports to limit the amount of time unexpected news can screw up a short and in the case of high borrow fees reduce time held.  Also when the stock price drops, so do the borrow fees so 30% can be reduced to say 10-12%, which is nothing on a stock with the implied vol. of RVLT. 

 

Sometimes planning to sell short too close to the news can be expensive.  I spotted the Poseidon fraud in august, but being very cautious and not wanting to lose money on the way to zero, decided to sell it short on Oct 15.  Unfortunately it became impossible for me to short it on the TSX a week before, and I never got the chance.  At least I sold out my massive long at a nice profit.

[ItsAValueTrap]

The best way to short is to buy puts.

 

If you short common stock, there are multiple ways that you can lose money even if you're right.

Same with puts...you need to be right about timing, and premium paid.

 

Try it on the really flawed companies out there (especially the pump and dumps)... you'll find out what I mean.  My blog post (http://wp.me/p1mOGr-y8) covers the dangers of shorting common stock.  With put options you avoid almost all of those problems.

[Valuebo]

If I'm not mistaken you can't buy equities with the proceeds from going short? But I assume it's perfectly possible to go short and go long additionally on margin (of course within the limits of your margin requirements).

 

And where can you find the interest cost for shorting a particular stock or ETF?

 

I ask this because today I have been thinking about the possibility to short one index (max 10% of portfolio) and maybe going partly long others through ETF's. Say short the SPY ETF and long 50% of my short position on Russian/Chinese ETF's.

 

I have some put positions on the S&P500 and some individual companies but those are just a form of insurance and I would never short a specific company. I could easily take the performance drag on a 10% short position on the S&P500, even if the market doubled from here in a short time frame. Can't really say the same from 10 1% short positions.

 

What do others with shorting experience think?

[frommi]

Ah thank you tombgrt, i just slapped myself for not thinking about buying a put on the index. That is a lot cheaper than on something like TWTR. After reading a lot i really don`t like to directly short a stock. Something that happened at VW can happen in every stock and i really don`t want to get caught in that kind of situation.

I looked it up for SPY, a at-the-money put option has around 5-6x upside if the market crashes by 40%. So in that case with a 5% short position i can reduce the maximum drawdown of the whole portfolio to around 10% ( in theory  :) ) and have a big buffer to invest when that situation unfolds. That can even allow to get deeper into margin.

I should do a backtest and see if that was adding value in the past. I allways liked to go out of the market from may to october, but that can be the solution i looked for.

[frommi]

In the last 44 years there were 13 drawdowns greater 20%, thats around one every 3.3 years. When i buy every year a one year put option for the portfolio, at the current prices of the options that costs me 5% in every year that that doesn`t work. So i loose 3.3x5%=16.5% in 3.3 years. In that one year it works i win ~15% assuming that the put option goes up 3x. (with volatility increases that can work). In the year following the crash year i will get 15-20% higher returns as without the puts because i can invest at lower prices and the following returns are on a higher base.

 

This can be surely be optimized because i don`t have to hedge every year. But for 2014 its probably not a bad idea to do it. There is only 1 crash in the next 3 years necessary to profit from the hedges. (It surely doesn`t work when the market rises to the middle of the year and then crashes to the level of the start of the year.)

 

Any thoughts?

[Valuebo]

Maybe I would dare to take a minimal short position in TWTR if it was valued at say $100B but what effect would that have on my portfolio anyway? If it halves I get a 50% on what could be a 1% position at best. Meanwhile it also costs me money to borrow and a lot of extra uncertainty added. Who knows how long those nutty valuations remain and what they do to monetize more of that valuation... It just doesn't make much sense for me to short individual companies.

 

On the other hand, going short an index and using margin to go long undervalued stocks can move against you (twice...) just as hard.

 

 

For those interested, I found some answers related to my beginner questions here:

http://ibkb.interactivebrokers.com/article/232

[frommi]

On the other hand, going short an index and using margin to go long undervalued stocks can move against you (twice...) just as hard.

 

Yes but i have a diversified portfolio of mainly bluechips at the moment, so it moves with the market up and down. (But with a little bit of alpha on my side at the moment)

And i am currently only 4% on margin, thats hardly game breaking. With a concentrated portfolio approach in smallcaps or high beta stocks i wouldn`t mind doing it. I am perhaps a little pussy but i don`t like high volatility when it runs against me and on the other side i am not able to sit on huge amounts of cash. Everytime its there i want to lift my passive income with it.  ::)

[Valuebo]

I have thought about shorting ETF's and indexes some more over the weekend. Found FDN and PNQI, two not actively managed ETF's focused on internet companies.

 

http://etfdb.com/etf/FDN?domain=etfdatabase&display_ice=&sym=FDN&studies=Volume;&cancelstudy=&a=M#holdings

http://etfdb.com/etf/PNQI#holdings

 

I have yet to look up the borrowing rates but expense ratio is ok at 0.60%. You can look at their holdings and other facts in the above links.

Through those ETF's you would get specific focus on (what most believe to be) very expensive stocks such as AMZN, NFLX, FB, CRM, LNKD, ... but you also have to take GOOG, YHOO, EBAY,.. etc with you for the ride.

FDN has 41 holdings while PNQI has 84 which I both consider safe enough in terms of diversification. Any 5%+ position that quadruples from this point (say Amazon valued at $700B+...) would at worst have a 1-2% negative impact on a 5% portfolio short position.

 

I am thinking about this idea as a possible pair trade with selected value stocks but I might be a few quarters (or even years) early. What do you guys think?

 

Here is a more recent fact sheet for FDN: http://www.ftportfolios.com/Common/ContentFileLoader.aspx?ContentGUID=3ee53ac7-d847-4709-8b5d-6e9459ef4e0e

Mind the historical returns... Checking the temperature with a smallish position now and jumping in with a big splash once the market overheats (a double/triple in NAV?) might not be such a bad idea. Comments or better alternatives would be very appreciated.

 

[constructive]

FDN and PNQI look like they have potential.

 

Also check out SOCL. http://etfdb.com/etf/SOCL/#holdings

 

Average trailing PE of ~125, forward PE of ~100.

[frommi]

And now don`t directly short it but buy the etf and sell 3xatm call options. That way you profit when is goes down a bit or it goes up a bit. That looks like a fireproof way to make print money.

 

For example for SOCL, when you sell 3 22$ Feb14 Calls and buy 1xSOCL you win when in 6 weeks the etf is between 19.8$ and 23.1$. You make the greatest profit when it stays at 22$, then you make 84% annualized, at 21$ around 47%.

[ItsAValueTrap]

If you have a retail account, you may be better off just buying the put instead of making a synthetic put.  The put may be cheaper if the broker won't pay you the full rate for lending your shares out.

 

2- I think the opportunities in shorting leveraged ETFs have mostly been arbitraged away???

 

If the borrow was free, you could print money by shorting both the bull and bear ETFs.  ([link=http://glennchan.wordpress.com/2012/11/07/leveraged-etfs-a-market-inefficiency/]I've explained this on my blog[/link].)  Because these ETFs may burn through 5-20% of the AUM in transaction costs each year, this would generate easy profits.

[Valuebo]

And now don`t directly short it but buy the etf and sell 3xatm call options. That way you profit when is goes down a bit or it goes up a bit. That looks like a fireproof way to make print money.

 

For example for SOCL, when you sell 3 22$ Feb14 Calls and buy 1xSOCL you win when in 6 weeks the etf is between 19.8$ and 23.1$. You make the greatest profit when it stays at 22$, then you make 84% annualized, at 21$ around 47%.

 

And then I run the risk of getting slaughtered if the  etf runs up a lot? That is exactly what I want to avoid? On the other hand I just collect premiums and losses from the etf I bought if it drops a lot, the exact outcome I predict over time compared to other sectors and regions. Also, I would probably lose more return from option pricing spreads and more transaction costs.

That doesnt seem like a hedge but a timing bet on the movement of the market, all in al for a low risk adjusted return.

[frommi]

My thought was that the possible outcomes of stock prices in x days are under a gauss curve. So if tommorows stock price is todays +- y and y is random, that leads to a distribution curve where a high amount of outcomes are centered arround the current price.

 

When i get the most profit at the top of the curve, i have a high winning chance. At the tail ends i have to do something. You can simply cut your losses or sell more calls with a higher strike.

 

You can create other bear option strategies like bear call spread, but then your maximum loss is exactly at the current price, which is bad when i am right about the distribution curve.

 

More about option strategies http://www.optiontradingpedia.com/free_deep_itm_bear_call_spread.htm

 

I am testing my strategy now with TWTR. I sold 3 Call option contracts and bought 100 stock. I will report how this worked out.  :)

[dpetrescu]

I've had great experiences with simple single leaps purchases. I'm not fond of complex combination strategies. For any very high conviction longs and good conviction longs without high volatility  I'll purchase out of the money calls. For good conviction longs with high to very high volatility, I'll sell medium to long term puts equivalent to the position I would hold. For shorting, I own modestly out of the money puts. Right now I own puts on GME (best conviction) CRM (most sure I'm right but also most sure I'll lose on this), and OUTR along with small amounts in NQ and OMEX. Ive had horrible luck with shorting, they just get more and more expensive. GME is showing some signs that it is heading lower but that's about it.