Shorting Stocks, a Primer

Reinhard Seiser
September 28th, 2006

The following comments summarize some of the aspects to consider when shorting stocks.

1. The Prelude

I have about six years experience in shorting stocks, and lately things seem work out more often than they fail, but it is very, very hard to do well, and I want everyone to be aware of all the little details and risks. Before my post, a little anecdote how I started as a rookie and got my wings clipped.

It was about the end of 2000, the stock-market had declined quite substantially, and I started to analyze companies in more detail and also looked at their actual numbers such as earnings and revenue, and compared them with earnings a few years back. What I realized was that this whole thing was a joke, especially internet companies trading at 10x sales, what seemed to be quite mature companies. I mean, if they could maybe get profitable and say make a 10% profit margin, they would trade at 100x earnings. I thought I would take my chances and wait for the opportunity and put on a big short position. I knew from reading all the stories that shorting was very dangerous, and that the losses can be infinite, etc. I also knew the saying that high valuation alone is not enough reason to short a stock. So I found two companies that had just broken down below a support line, and I thought I would short them and have a mental stop-loss if they made it back above their support level. I didn't put in any actual stop order, since I didn't want to lose on some 5 minute blip, and since I was practically sitting on my computer screen all day anyways. The day was Jan. 3rd, 2001. I rode my bicycle to work which took about 10 minutes, and exactly during those 10 minutes, Greenspan announced the first surprise interest rate cut, totally unexpected for me. The stock market was screaming higher, and my two stocks that I shorted, were up 20% a piece. Talk about timing. I still hear my friends laughing what a terrible trader I was, since only I was able to pick two stocks that would lose me 20% in one day.

What did I do next? Basically, back then I still believed in the power of interest rate cuts, and after a little drop I covered half of my shorts, and a few days later I covered the rest with about the same loss. The companies were NTAP and NETE around $50 and $40, respectively. Needless to say, that both went into the single digits within the year, unfortunately without me. During the Nasdaq decline, I also had some put options on the QQQs which I bought in 2001, and I have to report that I hardly made any money, simply because the premiums ate away most of my profits.

2. The Expectation

We all dream of getting rich, but let's be realistic how much one can make in the stock market. Let's start on the long side. The world's best investors (Warren Buffet, Peter Lynch) made about 25% annually, and maybe some traders too, whose names you never hear. That of course over extended time. All the others try to beat the market (S&P500) and as you know most are not successful, although the S&P only returned about 9% annually. Why can't you beat 9%, sounds like a piece of cake? Very simple, because there are stocks that crater just when everyone talks about how great they are (Enron, CSCO, YHOO), and you might have accidentally picked one of them. And there are also some huge winners in the S&P that just recovered 10 fold from their death (K-mart/Sears, Freeport, Frontline), and you probably didn't buy them either. Rather, at their low you were sure they would go bankrupt. Now you know why Bill Miller beats the market every year. I suggest to you that you try this for yourself for a few years and you will have the answer pretty quickly by how much you can outperform the S&P if you allocate a fixed amount of capital entirely to stocks. The other way to come out ahead is to time the market, e.g. sit out with certain portions of your capital during the down years. This is also very difficult, since if you guess one year wrong, you are way behind. This is even more difficult to practice since it would take decades to prove if you can do it. Most of the years are simply up rather than down. Considering all this, it is quite difficult to make compounded 15% annually, even though two factors are in your favor: Inflation (not much of a real benefit) and earnings (through dividends and internal reinvestment for growth). Both of these factors might make this typical appreciation of 9%, so if you make 15% annually, you in essence outperform the market by 6%. This is before tax, and after tax things will look much worse. (You also created more taxable events if you change your stocks more often than being long the S&P.)

3. The Problem

Now let's go to the short side. All things being equal, meaning that you try to pick stocks in your favor or try to find a year where the market is down, you now have this average 9% (inflation+earnings) going against you. This is exactly the opposite of the long-side, where you had a 9% tail-wind, and now you have a 9% head-wind, so you have to be incredibly good in finding the failing companies or timing the down year right. Even if you manage to pick the companies that are 6% worse than the S&P in average over time, you might still lose money. Remember again, that you might think which company goes down or which year is down, but in average your right and wrong guesses can come out less than break even, due to the above described tendency. Another detail is of course that a stock doubling against you puts you more behind than a stock dropping in half in your favor. (See adding to you short position at the bottom.) Another disadvantage for the small investor is that the cash balance when shorting does not earn interest. The broker simply earns this interest on a client's cash who short-sold a stock in the open market. Worse, some brokers count your shorts as additional margin, which limits the maximum long positions you can enter. Last, the tax treatment is more favorable to long positions that are held more than one year (15%). Gains on short positions are always treated as short-term capital gains (your income tax bracket).

To recap, what are the main points I want to make? a) Everything equal, it is more difficult to make money on the short side than on the long side. b) The gains are generally small, and one cannot afford to throw away even small percentages that one could save otherwise.

4. Reasons to Short

The risk one is taking on shorting depends very much on the approach. I want to summarize a few types of shorting strategies that are typically used. Keep in mind, I am talking about a little longer term positions. This is pretty much irrelevant for traders, since for single quick trades, long and short are not too much different.

a) Equity hedge or sector hedge

Here, one only shorts stocks to an amount less or similar to that one is long. If an investor has a talent to pick stocks, he might go long on certain equities, maybe the ones that provide value. At the same time he might go short on stocks he thinks have no value and are just dragged along by the market. If the market rises or falls, the investor hopes that the gap between prices of longs and shorts will widen. The same can be applied to a sector. A valid strategy might be to go long on commodities and short on stocks, assuming that we have entered a commodity cycle similar to the 1970s. Here, one counts on the out-performance of commodities, which at the same time will depress earnings of general stocks. With this hedge, one becomes more or less independent of inflation, i.e. the action of politicians, and depending on how much money is "printed" either commodities will go up or stock might go down.

b) Shorting overpriced assets

While this would have worked for internet stocks in 2000, most veterans warn that it is a dangerous play, since stocks can easily get two times more overpriced, which would lead to a total loss of capital. On the other hand, if revenue is so low, and earnings are not there either, company losses work in one's favor and one only has to battle against inflation and could afford to be short the stock for a while.

c) Shorting based on forecast

Not many people have the talent, but if you identify strong trends, you could short certain companies or sectors in the assumption that the crowd will be way behind. It looks easy after the fact, but who would have known how far commodities can go down after 1980 or technology stocks after 2000. One might also dare to make conclusions from the past, by looking which sectors followed one another, and by knowing that nothing is isolated. One sector might crash, and in its wake pull another sector down, etc., something that most people are blind to.

d) Shorting dishonest companies

Even here nothing is guaranteed, since the most crooked companies could be the best salesmen, either for their stock or for their inferior products. But over time few businesses have survived unless they have a product or business model that works. If one has the information, it is probably easy to identify the frauds. If managements pay loads of stock-options to themselves (10-20% annually of shares outstanding has been seen) they certainly might have a bias to enrich themselves rather than the shareholders. One could listen to their conference calls and find that they are just full of it, and that there is no intention to actually make a useful product. Similar is the hype when companies are jumping in on the latest fad, like optical networking, or adding “.com” or “nano’ to their name.

5. The Solution

There is no solution. The same as there is no free lunch. But there are plenty of tips. First, analyze your own situation: If you are a large investor, you might be able to get good short conditions from a broker (collect interest), and commissions will be small on a percentage basis. If you are a talented investor, who can make huge gains on the long side from time to time, you might do well on the short side too, and you might make up for the costs associated being short. If you are a short-term trader, this whole article is not for you, since you will have your own signals. None of the above? In this case you risk losing money and should only risk a small amount of your wealth. This will allow you to develop a system or identify an edge.

6. Other Details

An alternative for the small investor is to use put options. If they are in-the-money, the premiums are generally smaller, while the intrinsic portion is higher. The premiums contain interest rates, dividends, volatility, and investor expectation, and they get counted to your cost basis. They are therefore automatically deducted from your gains and translate into lower taxes. If interest rates are low (because of low inflation), volatility is low, and investors lean to the bullish side, then one might get a very good deal. If interest rates are artificially low to cause inflation, then of course any shorting is handicapped by the rising prices. Longer term options are generally cheaper than renewing several shorter term options, and there will be less transaction costs. Options on indices have usually lower premiums than the individual stocks, since the index will be less volatile. If one believes that technology stocks will drop, one might be much better off buying puts on the QQQQ, than on INTC, MSFT, DELL, CSCO, etc. Often it turns out that all companies in a sector pretty much track each other.

Another add-on is the writing of out-of-the-money put options against one's shorts or long-term puts. These serve more or less as limit orders to cover the shorts. By writing occasional front month puts, one can recoup valuable premium, and get paid a little to make up for the time waiting for stocks to drop. These should be used whenever the market is oversold, and one should keep in mind that they limit one's upside. But homeruns in shorting (e.g. Enron) are so rare, and the biggest gains in shorting are made in the beginning (where a certain percentage drop translates into a larger dollar drop). See more below.

If one is absolutely sure that a company will go to zero, one can add to the short position on the way down, reinvesting the profits, and continuously make money. This has to be treated though with stop losses or a trader's hand, since any bounce can wipe out all previous profits.

The entry point to initiate a short position is one of the most important tasks, together with a possible stop-loss, which most traders or investors apply. What makes an entry point so difficult is that on the way up there is no catalyst, and after a sharp drop, the price appears too low already to be safe. Some statistical or technical analysis might be helpful here, such as overbought conditions for getting in at a top, or breaks of trend lines to get in on the downtrend.

7. One possible strategy

My personal favorite is to initiate a short position by buying an in- or at-the-money put several months out and at the same time selling an out-of-the-money put with half the duration. This cuts down on both the risk and the reward, and one can still have a stoploss and get out of this so-called spread. But if one is unsure to take a loss if the stock goes up, one has at least a few more opportunities. One is to buy back the sold put and keep the long put running as is, sort of as insurance against other portfolio long positions. If the stock drops, one can write again the out-of-the-money put to almost break even on the whole trade. If the market doesn’t move much, then the shorter term out-of-themoney put always makes money faster than the in-the-money put loses. Ideally, if the stock drops just a few percent until the shorter term out-of-the-money put expires, like it often happens, then that’s the point of maximum profit, and one can write another now lower strike put and make again money. This advantage may adequately counter the cases where one was wrong and the stock went up. Last, when the stock drops really hard, like after missed earnings, one has to take the now limited profit (the difference between the two strike prices). But sometimes even after disastrous news, the stock doesn’t go straight down and actually bounces back big time. And now one can reload the whole thing again and make again a profit if it drops anew. These couple of profits would also justify to take one’s chances at some point and wait for bankruptcy, and only keep the long put. But this time with the house’s money, since the profits already paid for the last long put option. This one by now should have a longer date and a lower strike price, so one has nothing to lose if the company suddenly turns around or gets bought out.

Maybe this strategy is nothing for a pro, but it beats being short and having sleepless nights if a stock screams higher. It also beats paying continuously for put options, which eats away precious funds that one could continuously earn interest on. And it keeps one nimble to realize that the larger gains in one’s portfolio have to come from income generating investments on the long side.

Disclosure: Author is short several financial instruments.

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