How Regular Investors Make Money Shorting Stocks

by: Efficient Alpha

By Joseph Hogue, CFA

This is the fourth of a series of articles that explore the myths in popular investing as exposed in Michael Dever's new book, "Jackass Investing." In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling. For an introduction to the series and the book, see our previous article looking at the return drivers for stocks.

"I will hurt the shorts - and that is my goal," was the message of Lehman Brothers' CEO Richard Fuld in April of 2008. Unless you are under the age of three, or having just emerged from your Harold Camping-inspired bomb shelter, I don't have to explain in detail why Fuld was so irate at short-sellers. During any market crisis, just turn on your TV and you'll hear multiple stories about how short-sellers and speculators are heartlessly driving down the prices of stocks. What the media (and many a company CEO) won't remind you is that it is rarely a financially healthy or well-managed company that comes under short pressure. As in the case of Lehman Brothers, it wasn't the short-sellers that killed the company, it was a perversion of the securitization process and manipulation of accounting rules that killed the firm. I won't stay long on my soap-box, but the whole story really incenses me. A 158-year old titan founded by immigrants, the American Dream, brought down by irresponsible - no fraudulent - management.

Oh no, it wasn't the shorts. It was poor management that killed the beast.

What Is Short-Selling?

Before we get into the details of a short-strategy or some of the risks, I'll provide a brief rundown of what short-sellers do and how the process works. When you buy a stock, you are said to be "long," or have a "long position," in the shares. You do this, presumably, because you believe the price of that stock will increase in value over a given period. If, instead you believe the stock will decrease in value, you can borrow shares and sell them to another investor. This process, selling the shares without actually owning them first, is called "selling short," or holding a "short position," in the shares. Just as the long position makes money when the price increases, the short position makes money when the price decreases. Investors with a long position must sell the stock to close out the holding. Investors with a short position must buy the stock, and return it to the lender, to close out the holding.

The only difference between short-sellers and investors closing out their position in a company is that the shorts are acting on their negative view of the company before owning the stock. Nobody ever accuses the long investors, as they close out their positions, of crashing the market. Then why is there such a taboo against short-sellers? I think this is one of the few myths exposed by the book that isn't so much perpetuated by conventional investment theory, but by the media and politicians looking for a scapegoat. The author cites several examples in the book, including the story of the world's first multi-national corporation and the accompanying first short-sale. The reason short-selling carries so much baggage; I think it's a little bit of envy and a lot of jealousy. Misery loves company, and when everyone is losing money in the market, no one likes the guy whistling his way to the bank. People want someone to blame (or in our society, to sue) and who better than the guy who just made a windfall?

Short-selling does not destabilize markets or put undue downward pressure on stocks. In fact, we often see the market decline faster when bans are placed on short-selling than when investors are able to take either position. One such short-selling ban, on financial stocks, was put in place by U.S. regulators effective September 19, 2008. The author points out that, "over the two and a half weeks beginning on September 19, 2008, the length of time that the short-selling ban was in place, the Dow Jones Industrial Average plummeted more than 2,000 points, or 18.7% and the S&P 500 dropped 21.5%. Even worse, financial stocks in the U.S. - the very stocks that were protected by the short-selling ban - fell a much greater 31.7%, as exemplified by the Financial Select SPDR (NYSEARCA:XLF)."

Why Individual Investors Have The Advantage In Short-Selling

There are three reasons short-selling should be added to your toolbox of strategies, and one of them gives small investors a distinct advantage. First, statistical evidence on the distribution of returns to the market shows that stocks have a negative skew. This means that the tendency for stocks to have large losses is greater than moves to the upside. We'll dig further into this phenomenon in myth #7 of the book, but if you look at the 60 best and worst performing days in the stock market you'll see that the risk to the long position is actually greater than the risk to the short side.

Sell-side analysts, those actively selling their opinions on stocks, are much more likely to give buy opinions on a company's shares than hold or sell recommendations. There are a couple of reasons for this. Many of these analysts collect fees from issuers to analyze and recommend their shares. Though it is possible for an analyst to remain objective and give an honest opinion on an issuer-paid report, the critical analyst will soon find his pipeline dry if he gives too many hold or sell recommendations. Second, analysts quick with the sell recommendation may find themselves shut out of company conference calls or unable to reach insiders for valuable information. Finally, though the investment banking divisions of major firms are supposed to be held separate from trading, there is still significant pressure on analysts from within the firm. The IB division makes its money being a provider of financial services to companies. Critical analysts and too many sell signals make it harder for IB to keep clients happy. With even the bad companies receiving a buy or hold recommendation, stocks are much more likely to be overpriced and present an opportunity for short-sellers.

Many large institutional funds, particularly endowments and foundations, are prohibited from short-selling. The myth that short-selling is riskier, or in some way malevolent, is hard at work here. This presents an advantage to the individual investor who has the flexibility to go long and short. Additionally, typically short interest accounts for less than 5% of outstanding shares meaning the market is overwhelmingly long. With fewer market players in the short game, the market is less likely to be efficient.

Risks To Short-Selling

I love the advantages short-selling provides the individual investor. It is not often that the average Joe has a distinct advantage over the institutional players. Like many investors, however I am a little hesitant to use shorting. As the author's reference to the many asset bubbles shows us, and as Keynes said, "the market can remain irrational longer than you can remain solvent." This is really the primary risk to short-selling. As a borrowed asset, the losses on shorted stocks must be covered in your brokerage account as the shares increase in price. If this happens for a long enough period, you could be forced to close out the position before it has a chance to profit. Analysts were decrying the subprime bubble back in 2004, four years before it burst. Those that shorted upon the first signs of trouble saw the market increase another 40% before finally coming down. For this reason, I only use short-selling as a hedge or within a long/short strategy in my portfolio.

Another risk to short-selling is called the short squeeze. This happens when something causes the prices of a stock to increase and short-sellers start covering their bets by buying back the shares. If a large percentage of the shares outstanding are sold short, then there are potentially a large number of investors that will be buying the stock and some serious upward pressure. As the price increase speeds up, more shorts are compelled to close out their positions and a reinforcing loop is created. Since the upward climb of a stock's price is theoretically infinite, so are your potential losses. There are two things you can do to mitigate this risk. First, short interest data is available through Yahoo Finance by clicking on the Key Statistics link in the left-hand menu of each stock. The 'Short % of Float' is the percentage of shares outstanding and available for trading that are sold short. A percentage above 10% means the short-trade may already be crowded and there are a lot of investors that will eventually need to buy back the shares. As the percentage short increases, you may want to pull in some of your bets to avoid a short squeeze. Second, know the possible catalysts for the stocks you are shorting and cover your positions around those dates. Earnings always present a potentially dangerous day for shorts, as well as any announced press releases or company events. While many short-sellers will say that earnings are the best time to short bad companies, I don't like the risk involved with a potential surprise announcement.

Short-Selling Strategies

We'll cover three short strategies here: hedging, market-neutral, and short-extension. Hedge funds and traders are active in other short strategies, but I prefer these three methods. The author describes an actual trading strategy using the Piotroski scoring system in the Action Strategies section of the book. I will keep the content more generalized here describing the idea behind each approach.

You will want to employ a hedging strategy if you still want to keep a long position in the market or a specific stock, but are weary of potential market weakness. It works by finding an investment that is influenced by the same return drivers as your investment but with higher volatility. For example, I have felt that U.S. financial institutions are undervalued for the last few months. There are certainly significant risks but price-to-book values around one means you are getting the company for extremely low valuations. The economy is extremely slow right now, but will eventually rebound so there is an opportunity for the long-term investor. In the short-term, a default in Europe will send even the U.S. financials lower so this is something I want to hedge against. Because the European banks are much more exposed to EU country debt, I want to short those banks while holding my long position in U.S. financials. The Select SPDR Financials (XLF) is composed of financial firms headquartered in the United States. The SPDR S&P International Finance (NYSEARCA:IPF) ETF carries half its holdings in European banks versus a 97% weighting in US banks held in the XLF. This is actually a trade I wrote about in another article on July 15th of this year. To date, the 18.6% slide in the IPF has shielded me from most of the 20.3% decline in the XLF and there have been opportunities along the way to unwind the position with a gain. A hedge may not allow you to completely lay off your risks, but it will help protect you from the downside.

A popular way to hedge general market risk but still continue to hold the individual stocks you favor is through ETFs specifically designed to short the overall market. The ProShares Short Russell2000 (NYSEARCA:RWM) invests in derivatives to provide the opposite daily return of the index. The Russell 2000 index is comprised of the smallest firms in the Russell 3000 index. Small cap stocks are generally more volatile than other stocks during market weakness, so this index should decline enough to help you hedge your portfolio risk. There is also the ProShares Short S&P 500 (NYSEARCA:SH) for investors wanting to hedge their large cap risk. Investors can also directly short the S&P 500 with the SPDR S&P 500 (NYSEARCA:SPY) and avoid management fees associated with ETFs.

A market neutral strategy attempts to match up the long positions in the portfolio with an accompanying short position. Several characteristics of the two positions like: beta, correlation, sector, and capitalization can be matched up to remove market risk. Basically, the investor is trying to remove all risks that are external to the company in which the company is long. It's fairly quantitatively detailed to do exactly and involves regular trading to adjust positions so most portfolios are not completely market neutral. Creating your own market neutral portfolio will require additional reading. The ProShares RAFI Long/Short (NYSEARCA:RALS) carries equal weight on the long and short-side in an effort to create an absolute return over the market cycle. The fund has outperformed the S&P 500 by 3.3% over the last six months while matching its performance over the last year.

A short-extension strategy, often called a 130/30 strategy, involves investing 130% of total funds in a long position and selling short to cover the 30% funds needed. As with other strategies, the 30% shorted funds can come from shorting an index or from stocks that mimic the performance of your long portfolio. The premise is to use limited short leverage to increase returns compared to a traditional long portfolio. The ProShares Credit Suisse 130/30 (NYSEARCA:CSM) fund has outperformed the S&P 500 by 1.7% and the Russell 3000 by 1.2% over the last year.

How you select the equities or funds in your short portfolio is usually the same process by which you select those investments to buy. This is particularly useful because it helps to ensure that the shorted companies are closely related to the long portfolio, but with weaker fundamentals. Read up on a few more strategies or short-selling in general before you jump into any large bets. There are risks involved, as described above, but overall short strategies can provide an enhanced return and help to mitigate risks within your portfolio. Do not simply avoid the opportunity because of what the media would have you believe.

Disclosure: I am long XLF.

Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.