Zero Shorts: Beware 'Free Money'

Wrong:

Something for nothing.

Intellectual and financial achievement.

We showed those losers.

Hey, it’s free money!

Possibly Right:

Don’t play for the last nickel. It may cost you a buck or more.

Shorting is not the opposite of being long, it is the opposite of being leveraged long. You don’t control your trade in entire, and the margin desk, or fear of the margin desk can make you leave a trade prematurely.

Pride goeth before a fall.

Would you rather be right, make money, neither, or both?

Free money in the market exists until too many people start searching for it.

Whom God would destroy, He makes overconfident.

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Though I do risk control different than many people, risk control is behind much of what I do in managing money. Avoid risks that I am not being paid to take, and take risk where I am getting fair compensation or better.

Now, I can think of several companies where I think the common is an eventual zero. Fannie, Freddie, AIG, GM, and Ford (I am less certain about the last one). My calls on GM and Ford were ones made long ago. The same for Fannie and Freddie. AIG is more recent.

Now, I rarely short, because my risk control methods are not designed to work with shorting. But one thing I would almost never do is try to “zero short” — short a stock to zero. As I have said before, seemingly free money brings out the worst in people, and makes them play more aggressively than they should.

Don’t underestimate the power of control. There is an optionality there that is underappreciated. With the right offer management can sell assets, change the capital structure, get a bailout, etc.

Don’t overestimate the uniqueness of the reasoning involved. Zero shorts attract parties wanting to short to the bitter end; they think that zero is inevitable. No risk here. One decision.

I would look at the borrow. Can I borrow a lot more stock easily, without paying a premium either directly, or indirectly through the cost of some derivative instrument? (options, swaps, etc…) If I can, perhaps I don’t have to worry so much about losing control of the trade. If not, it may be time to close out the trade (for a little while, then re-evaluate), or at least evaluate how high the price could go in a short squeeze. As we have seen recently, some lousy companies in a short squeeze can double or triple. Would I have enough capital to carry the trade under such adverse conditions?

At least I should estimate short-term upside versus downside for that position versus others in the portfolio. After a successful short, it may not employ a lot of capital; perhaps I should close it out.

What’s that you say? The borrow is plentiful, and I should short more? After all, it is going to zero. I would not do it because the upside/downside ratio is worse than when the trade began. Figuratively, playing for that last nickel could cost me several bucks.

What if the position moves against me and the borrow is plentiful? Should I short more? After all, it is going to zero. Sigh. Review the thesis. I might look for someone who doesn’t always agree with me, and ask him what he thinks. If the thesis does not change, I would short a little more once the momentum against the position has stopped.

One more note: I review pricing across the capital structure. Where does the bank debt trade? Where are Credit Default Swaps [CDS] trading? Yields of senior unsecured notes across the maturities? Junior debt, trust preferreds, hybrids, preferred stock, etc… These are all relevant bits of data to tell whether the common stock will indeed zero out. If the next most senior class of capital to the common is trading above 50% of par, I would do more research on my thesis. If it is over 80% of par, the zero short is not a good idea.

Risk control wins in the long run. To me shorting all the way to zero is a risky way to do business, and so I am very unlikely to do it. There is a pride element involved, and all good investing relies on having control over your attitude. If you decide to zero short, be very careful. It is not as easy as it looks, even if in the end, it does go to zero.

Comments

[Cicco:]

I was able to find 500.000 shares to short GM. Why shouldn't I?
I'm selling 500.000 shares at 1.19 and selling 5.000 (500.000 shares) Put options June Strike 2.00, Price 1.36.

I've margins large enough for a X3, why not do it, company will be BN in 30 days.

May 14 01:34 PM

[Cicco:]

Please read BK (Chapter 11), not BN in the post above.

May 14 01:35 PM

[GoochyPuppy:]

Cicco,
Doesn't your position have the _possibility_ of infinite losses (i.e., it is non-constrained risk)?

At June expiration, your break even is roughly $2.40 or below.

I am also extremely bearish on GM (doh!), but "what-if" some magic happens and there's a buyout offer of $5 or $10 / share? Is it worth THAT risk? If I calculate correctly, your max gain is $200, but you could quite possibly lose 10x that.

Why not BUY straight puts and limit your losses?

May 14 04:34 PM

[Cicco:]

If I really wanted to be protected it would be VERY easy and cheap. I can just buy 500.000 strike 2.00 Call at 0.10. In this case the trade would be perfect, but do I really want to throw away 50.000 dollars to cover the risk GM goes Up 100% in the next month?

In two week there are 2 potential outcome:
- bankrupcy, common in this case are worth close to zero
- restructuring, in this case current common will get 1% of new entity, I would say that new Company will be worth max between 0and 30 BN, that is 0.3 - 0.4 per share.

If you make the calculations buying the straight Put is extremely more costly than the 3 combined I described above, with the same profile, extremely.

P.S. A buyout offer on GM ???????????????????????

May 14 06:16 PM

[AJB7:]

Cicco wrote <I was able to find 500.000 shares to short GM. Why shouldn't I? I'm selling 500.000 shares at 1.19 and selling 5.000 (500.000 shares) Put options June Strike 2.00, Price 1.36. I've margins large enough for a X3, why not do it, company will be BK in 30 days>

It looks like your trade will make about $80K at GM zero. With protection of the long 2 strike june call at .10, you still will make $30K. Without the long calls however your position risk is unlimited and you could blow out on a freak occurance.

I've been on Wall st quite a while. I've known quite a number of millionares in the morning who were broke by the afternoon because they took unlimited risks for "sure things". Pretty much the same thing happened to Long Term Capital which should have known better. 99 times out of 100 you'll be right. But when you're wrong (and you will be wrong in the long run) it'll be your last trade.

May 14 09:11 PM

[Nettligent:]

NETGEAR (NTGR), SYMMETRICOM (SYMM), STEC, ATHEROS are perfect stocks for SHORT. Check Out.

May 14 09:48 PM