rossetti2000

Who Will Trigger E*Trade's Magic Moment - and a 111.4M Short Squeeze?

I agree.

There are basic rules when shorting any stock:

First: those investors who choose to short a stock have to be ready for a long-term commitment, and the chosen stock should have relatively very little value.
Second: Shorting a stock should evoke the thought of becoming a penultimate risk manager. For example:
Before taking the "plunge", short traders should think about responding to a Dirty Harry–like question. However, instead of, "Do you feel Lucky," the question might be, "Can you handle the share price doubling." Short traders should not want to bail and sell at an insanely high price. Most players who trade short want to stick it out, to "invest" for the long term (like longs are prone to do). However, there is more risk for short traders, because large short positions are dangerous. Any sudden shift in opinion or momentum could pop the share price and rapidly devastate traders who are late to cover a short position.

Third: Shorts have to bear value investing in mind, and they have to remember that takeover values are related to market values. If a market is crazy, takeover values might be insane. In addition, shorts must be vigilant about certain "special events" and here are a few events to consider:

Recapitalization;
Share Buy Back ;
A takeover ;
A change in management ; and
Any similar event that might force a trader out of a short position.
If a short trader is holding a position and the particular stock starts going up, but not too wildly, a short (like a long) might choose to average in.

With the discussion outlined above in mind, let's take Etrade as an example. Let's hypothesize that a trader expects Etrade to go bankrupt under toxic mortgage debt and other financial pressures, and the trader shorts Etrade at $2.08 In January 2008. Then E*TRADE's share price moves rapidly to $3.00 a few trading days later, that short might assess special events before averaging in, such as:

1. E*TRADE's recapitalization (the consequence of the November 2008 Citadel bailout);

2. E*TRADE's share buy back potential (and it was clear that there was no such potential at the time);

3. A takeover possibility (At the time, chances of a merger were slim to none after the Citadel deal, because Etrade chose a bailout and it was left with a lame banking arm); and

4. A change in E*TRADE's management (there was no real change at the time except for Caplan leaving, and Layton becoming a figurehead chairman).

The average short trader might think that E*TRADE's HELOCs were a financial time bomb waiting to happen. In January 2008, subprime paper was a sure negative. Likewise, competition in the brokerage core was hard enough to contend with (e.g., Scottrade, Fidelity, BOA, Tradestation, etc.), without simultaneously contending with the extra heavy burden that had become E*TRADE's banking arm...so in late January 2008, even at $3.00 (a paltry price indeed), it might have been a wise decision to continue shorting Etrade. After all, the thought of E*TRADE's bankruptcy still loomed.

However, as we all know, at approximately $5.45 intraday in February 2008 (more than a doubling of E*TRADE's intraday low of $2.08), Etrade had almost made it up to $6.00, or nearly triple its lowest price.

But, in looking again at "special events" mostly everything about E*TRADE's status had not changed during its rise in share price to $5.45. While E*TRADE's general health might have improved, the improvement was certainly not enough to discourage short traders from continuing to average their positions on the way up. After all, without further news of great metrics (Etrade had reduced its metrics reporting from monthly to quarterly) how much more could E*TRADE's share price rise before the first quarter 2008 conference call? Therefore, short traders felt confident about adding to their positions and sending short interests into the stratosphere. In doing so, short traders accumulated total positions that would exceed the number of available Etrade shares to cover in the face of favorable special events.

However, special events mean more to a short's survival than they do to a long's eventual success.

For example in following the rules of shorting, short traders should keep the following question in mind: "Is there something out there, some news, and event, or a report that will take E*TRADE's price down, considerably?" Once short traders "buy into their short positions", their goal should be to hold their positions as long as they can. This is the paradox of shorts having to be "longer" than longs."

Therefore, in that long term short commitment, short traders have to keep their eye earnings reports and ask: "Will there be disappointment?" Short traders welcome earnings disappointment, especially in an overvalued stock. If the disappointment is big enough, short traders will pull the trigger and collect bountiful rewards.

To recapitulate, short traders look for the typical overvalued but growing company. Short traders do not take positions in companies that have real value, but they do take positions in companies that may have perceived value, or a rapidly sinking value relative to the current share price.

Short traders who follow the rules of shorting will not maintain a lengthy short position in any company where value is gaining on price.

On the other side of the coin, Etrade longs are convinced that E*TRADE's value is catching up with its price because:

1) Recapitalization has already happened with Citadel and recapitalization will continue with "front door" debt for equity swapping;

2) Share Buy Back seems more possible; E*TRADE's banking arm continues to strengthen and Layton might pull a Winter of 2008 surprise by plowing several hundreds of millions of dollars of no longer needed banking reserve into a share buyback program;



3) A takeover is looking better with each passing week, because the banking arm is becoming less of a problem and because Layton is "teasing" the toxic portion of it out of E*TRADE's financial makeup and business model; and

4) A significant change in management has taken place in 2008.

Once again, in assessing whether Etrade is a good candidate to keep shorting, the ever present question for short traders is "Do you feel lucky?" The translation here is, "Do you feel that you can short Etrade 'forever'?" Because long-term shorting is one of the cardinal rules for shorting a stock...a short trader must outlast a long-term investor holding similar positions.

There are a few other considerations for the short trader. One consideration is that shorting gains becoming ordinary income. Another worry is that if E*TRADE's share price rises considerably (i.e., presently, if it doubles to $8.00), a short trader's risk goes up with the share price. The short trader's risk increases exponentially, because Etrade (our example) becomes a considerably larger part of the short trader's portfolio. It is just the opposite for long-term investors; i.e., Etrade suddenly becomes a lesser part of a long's portfolio (a long can sell half of the shares and wind up with a welcomed paradox of taking the original investment amount out, yet leaving the original investment amount in).

So a word to those who are still brave enough to short Etrade...follow your cardinal rules of shorting; realize:

1) That E*TRADE's management has changed;

2) That Etrade is becoming more strongly capitalized everyday;

3) That E*TRADE's banking arm is healing and that the arm's toxic fat is disappearing;

4) That acquisition is looking better everyday;

5) That Layton could spring a share buyback program (large or small scale) at anytime he feels that he can release all or a portion of the conservative portion of E*TRADE's banking reserve;

6) That debt for equity swapping is now a reality, and that it will not be dilutive enough to cause a notable value drop; and

7) That E*TRADE's recent change in management was not conducive to a long-term rampage of shorting.

Those are the current Etrade shorting considerations.

In other words, realize that Donald Layton's supervision of E*TRADE's turnaround in Q2, Q3, and Q4 of 2008 will likely result shrinking losses and noteworthy gains for Etrade. Thereafter in following the cardinal rules of shorting, think about whether a possibility looms that Etrade will see $8.00 to $10.00 by January of 2009 (a doubling or better of the current $4.00 price). Lastly, reconsider whether any wise short trader will be able to be short, forever, if necessary (one of the foremost cardinal rules of shorting).

If the answer seems to be, "No," then rethink your positions and cover while you still have a realistic opportunity. Don't let the recent Proxy share authorization increase fool you. If E*TRADE's Board chooses to issue only a low number of those new shares, with restriction, E*TRADE's market trading shares may become very scarce indeed.

After all, how much more of E*TRADE's increasing value to share price movement (perceived or not) will a short trader be able to sustain in the long term?