Zero Shorts: Beware 'Free Money'

 |  Includes: AIG, F, FMCC, FNMA, GM
by: David Merkel, CFA


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.


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.