To Short or Not to Short

That is the question.

There appears to be a budding discussion on Vestopia over shorting, versus buying options, versus going long-only. Both Jaimi Goodfriend and Dan Knight raise valid points - Jaimi raises the issue of hedging your portfolio, and Dan raises the issue of reverse-engineering your long ideas to find short ideas. Yet the majority of investors go long-only.

Anytime a market sell-off occurs or we enter into a bear market, Wall Street and the press become enamored with short-sellers. Short-sellers, of course, do well in down markets. Generally, my opinion stands as follows:

1. If you are convinced the market is going down, then shorting indexes is a good way to make money (assuming you are right).
2. If you are worried about the market going down, but have no conviction, then I suggest money market funds instead of stocks.
3. If you have conviction about specific stocks going down, then shorting is a good way to leverage that conviction - assuming you can manage the risks.

The first lesson of short-selling, however, is don't do it just because it would have been a good idea over the past three months.

There are four key differences between short selling and buying long (other than the obvious directionality):
1. Dividends - you buy long, you get a dividend. You sell short, you must pay the dividend.
2. Margin requirements - if you sell short and the stock goes up, you may be required to put more cash up as margin, or cover. Volatility, therefore, is a key risk to manage.
3. Short squeeze - if a stock is heavily shorted, and the stock starts to move up, short sellers may all be forced to cover at once, spiking the price. Margin requirements then become a problem.
4. Stocks, on average and over time, go up. The expected rate of return is 8%-10% annually (+/-35% in any given year). Therefore any shorting strategy needs to exceed that rate of return to be additive.

In addition there are issues surrounding transactions costs and liquidity.

What about short selling and intrinsic value investing?
The intrinsic value investor is a long-term investor. We are willing to suffer some short-term volatility to realize long-term value. Long-term short selling, while possible, is challenging, as a stock's short-term volatility can trigger a margin call or a short squeeze (and the dividend, if present, can get expensive).

In the short term, absolute valuation discrepancies can widen before they close. A catalyst-driven approach usually works better, but often that leaks into an earnings momentum strategy. Therefore, adding shorts can have the counter-intuitive effect of increasing portfolio volatility for the intrinsic value investor.

Usually absolute valuation discounts cluster around industries and similar companies. It is unusual for one company to be severely undervalued and its identical competitor to be significantly overvalued, unless the first company has significant problems. Why would I want to short an undervalued stock just because its competitor is even more undervalued? Indeed, if similar companies are comparably healthy, then the difference in valuation is likely to be relatively small and within the margin of error, and overwhelmed by the industry discount or premium present.

Therefore, a market neutral strategy doesn't really work for the intrinsic value investor.

Market neutral and long-short managers often use statistical correlations such as beta and covariance to manage risk. These are fine in the short term, working within the statistical "bell curve." However, they are not usually stable over the long term and can break down suddenly without warning. Beta is not a reliable measure of risk over the long-term. In addition, market return distributions don't actually follow a bell curve and are subject to "fat tails" (extreme events happening a lot more frequently than expected). The fat tail phenonenom is a much bigger problem for the long-term investor, as a short-term investor just covers when extreme events happen.

That said, I am using thought experiments and test portfolios to develop shorting and options strategies leveraging my valuation work. It is not a market neutral strategy; instead it would be an absolute return strategy. Unfortunately, I can't learn much about shorting in a market sell-off (when all shorting ideas work regardless of merit). It appears that I would gravitate towards the use of option as a way to manage and profit off of the volatility, but I would not be limited by that.

I have made sparing use of options in my Vestopia portfolio, mostly implementing a "limit order" strategy profiting off of volatility premiums. Here, if there is a stock I am buying or selling, and the volatility premium is high enough, then I write a put or call effectively improving my price point on the transaction. If the stock moves away from you before the option is exercised, then you collect the premium (but miss the move).

I don't like buying options because I don't like paying premiums to limit short-term volatility. As a long-term investor, I can afford ride the short-term volatility - indeed, that's part of how I make money over the long term. I would only buy an option if I had a high level of conviction about the directionality of the price move over the option's life.

Comments

[Solution]

Why do I get dividend from QID ?
Look finance.yahoo.com/q/hp...
Isn't it supposed to short and pay dividend to others ?