A Short Comment on Shorting

Lately, Vestopia's Investment Directors have been chiming in heavily on the topic of shorting stocks. All investors want to make money, but when the market turns a bit iffy (like now), the desire to preserve capital comes to the forefront. Many of my colleagues have done a commendable job explaining their specific approaches to managing risk and even trying to profit from stock declines. I guess it's my turn to explain my approach to this.

First of all, I agree with Aidis Zunde (see his article here) that we are in a bear market. We can quibble all we want about definitions and such, but I am managing my portfolio with the expectation that we are in a bear market. If I am wrong about this, I expect to make more money than I will in a bearshould act slightly different in a bear market (see my blog on this topic here). I stress "slightly" because I do not think an investor should abandon his or her investment philosophy just because it's not working right now. Obviously, a philosophy that never works needs to be adjusted. Contrary to the popular press, "Buying stocks that only go up" is not a valid investment philosophy?

market (yay!). I think investors Shorting stocks. Daniel Carrol here) and Dan Knight here) have both weighed in this topic and I think their views are valid. As for me, I never short stocks. "Theoretical unlimited downside" is the first reason. When I first learned once could lose an unlimited amount of money shorting, it seemed to risky for my personality. Granted those who know how to short do it in such a way (stop losses, etc.) to avoid massive downside, but in my view it seems much more risky than owning stocks (where the theoretical downside is a more manageable 100% -- I know I've tested that theory!).

The second reason is psychological. As an investor, I know that one short position would probably stress me out more than everything else I own. While I can fully appreciate and understand the value of shorting stocks (I agree with everything the above authors say on the topic), I cannot (or have not so far) bring myself to being comfortable shorting stocks. This leads to the next topic? Options. Todd Chalem (here) posted a very helpful blog discussing the use of options in hedging one's portfolio.

Here too, I feel that my approach is a bit different than my colleagues. I rarely buy options. I tend to sell them with option volatility is high. I do this to slightly hedge the downside of a position where I have profits and I will do a buy/write on occasion if I think the expected returns are attractive. Usually, I target 1% per month on my option trades.

This may sound like small potatoes to some of the gun slingers out there, but this is what I am comfortable with. Sometimes I will buy a long-dated call and write shorter duration calls against this position. Given my opinion that we are in a bear market, I suspect I will become more active in this area. Speaking of which, I am thinking of doing a buy/write in the near future on a defense (not defensive) stock. Please watch my private blog for details when this happens.

Comments

[seriously ?]

liked what you had to say about stress... I always think that is MOST important.

If your portfolio is driving you nuts, you are doing it wrong!

I have being feeling very "settled" as of late. I sold off a good bit of stock when the fed started "injecting liquidity" and have recently started to straddle the VIX , so i'm longer cash now and have a small bet on GLD and a small bet on the volatility of volatility. I'm feeling little stress...

[Quaker]

I have to admit, your comments strike me as a bit odd. If you look at a chart of the DJIA over the last ten years, the general market's had 3 good years, one so so year and 6 bad years. 90% of the overall gain occurred in less than 36 months.

IMO, people who are afraid to short should invest in CD's. I don't mean this as an insult Mike and I hope you don't take it that way. Markets are designed to provide liquidity to illiquid things, not drive stock prices up. If the market goes illiquid (which it's in the process of doing as we write) all the fundamental analysis in the world isn't worth a hill of beans.

Oh and by the way, I'm up 20% YTD.

[fxtrader07]

Hey Quaker, fine that it works for you (these days). However, shorting stocks is a sucker's game long term. odds are very high against you. but confident as you sound, i am sure you will notice in advance when the market starts killing shorties again.
Btw, it strikes me that plenty of people got very rich long-term who never shorted or even directly hedged a position. I have yet to come across someone who got rich long term shorting - barring perhaps one out of a million who tried. if you are confident to belong to this 0.0001%, well go ahead. otherwise you might find out what's truly working long term the hard way
and not to forget: a strategy enhancing the profits by writing covered calls regularly or occasionally will probably beat a long-only or shorting portfolio most of the time

[Muzie]

Watching the news I know more state lottery winners than I know people who got rich shorting stocks.

Doesn't mean buying lottery tickets is a good strategy to get rich.

[zenalgorithm]

Shorting is very difficult, but I would rather short a stock than buy puts. Options IMO are a tremendous waste of time - a zero sum game after all that work. Options are great though for people with insider knowledge. Writing covered-calls is usually the only profitable type of option.

Check out: SDS, TWM, and QID if you want a better, safer option to straight shorting. I try not to ever short individual stocks unless BK is looming.

[readpiano]

While shorting stocks is difficult, it is not true that there are no rich shorters. Jesse Livermore and William O'Neal are two outstanding examples.

[GKM]

While I can appreciate aversions in an investing philosophy/psyche, you need to act within your limits - but act you should. If the author believes we are in a bear market, then you need to take actions to manage around that unless you are simply a buy and hold investor. If he is selling calls, that's a good first step. However that's not going to manage the rest of the downside risk to the length held.

As Zenalgorithm points out, anyone in this situation needs to take out the beta risk and take a short position with respect to a market index. However, the comment about options not being of great value is wrong. You need to employ the right option strategies in highly liquid options.

I find that using strategies that take out some of the exposure to the greeks beyond just delta are most effective. Use strategies like bull or bear spreads, butterflys, and condors to get what the average active investor might find helpful to manage their market outlook.

In any strategy though you need to consider your portfolio position, outlook on the market, risk tolerance, time horizon, and manage around all these things.

All this said, I'd be wary of being short much at this point (unless its short the US dollar). I read the tea leaves that a short squeeze is coming and wouldn't initiate any shorts until the rally starts to wain before the next leg down.

[zenalgorithm]

GKM,

From looking at the recent stubborn nature of the index charts, I agree with you that a short squeeze seems more likely than not within the next 6-8 weeks. Looking back at the 2001-2003 charts, the bear market index rallies seemed to hit resistance between the 100-150 day MA, then continue their next leg down.

[NutritionFacts]

Shorting: more difficult, definitely, but only because of the occupational hazard of The Squeeze. This does have the perverse advantage though of minimising portfolio risk: I am more conservative with my short positions simply because they are more risky.
Timing is everything.

[BrucePile]

Running a short portfolio is hobbled by some simple facts of math. For one thing, when you put a position at risk, you have to take a quick loss if you are wrong in the short term; and the short term movement even in a bear market is largely random noise with little predictability - close to a 50/50 chance of having the stock move against you right off the bat. So even if you are right about the longer term direction, you will be taking quick losses nearly half the time or be risking the bigger losses. And of the positions that go your way, you have another math fact working against you. If you put say $20,000 at risk and the stock tanks nicely from $20 to $10, you will be buying 1000 shares at $10 and creating a profit of $10,000. So on your $20,000 you make $10,000 - a 50% profit. But for the same % price move long, this would have been a 100% profit with the stock moving from $10 to $20. So even on your home runs, you are having your shorting profits cut in half versus a long portfolio. Then there is the real world matter of taxes. Most bear markets don't last much more than a year, and much of your short portfolio will be holds of less than a year. If your long holds are mainly more than a year, you will have the long-term tax rate of 15% versus the short-term rate of 30% or more cutting in half again your hard won shorting campaign profits compared to buy and hold long! So after all the added stress and worry of shorting, you are actually keeping just a sliver of what the same price movements would be handing you in long positions. No wonder there are so few rich shorters.

If there are no good bull markets to take advantage of, shorting may be better than cash if done well (and O' Neal shows you how to do it well in his books). But right now, there are some strong bull markets that probably have better net profit odds than shorting. The long-term debasing of the dollar provides good buy and hold opportunity in precious metals. And the agri crops bull market is driven by long-term supply and demand plus the currency issues. These will only be aided by a bear market.

[HedgeFundOfOne]

Grammatical errors aside, I thought that your article was a reasonable argument for doing what is comfortable. However, I find "comfortable"... to be uncomfortable. Comfort is an argument for mediocrity, in which case, I would just buy and hold index funds and be done with it. There are numerous ways to take advantage of share prices going down that are less risky than outright shorting the stock. Maybe get outside the box and explore them with small positions that will not wipe you out if they go against you. Even better, some brokers offer virtual trading platforms where you risk no capital while you learn something uncomfortable.

BTW, while O'Neal understands shorting, has done it profitably, and has written about it, he also says that he has not been as successful with shorting and that he has done it infrequently. He tends to trade from the long-side or the short-side only when the set-up is compelling.