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Valyooo (99.63)

Thoughts for beginners 3: Is shorting as risky as they say?

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March 15, 2013 – Comments (12)

I am more of a macro investor than individual stocks...not the best with those.  I remember there were a bunch of questions that I had that confused me when I was brand new.  A handful of CAPS players got me to where I am today, so I am offering my opinion on a few misconceptions.  There will probably be about 10 of these blogs over the course of a few weeks.  

 In this blog I want to explore the common misconception that shorting is much riskier than going long, and that only very experienced players can short.

 

What is short selling?  You open a margin account and elect to short a stock. This means you are betting on a decline.  You are borrowing somebody elses shares, selling them, and then to close the position you buy it back later on, hopefully at a lower price. 

First, I would like to point out that 1) Shorting can be very hard compared to going long 2) Shorting based on valuation alone is a TERRIBLE idea (as I said in a response to my first blog, a stock who had no problem getting a p/e of 120 will have no problem getting it to 300, and momentum can be very powerful) 3) Theoretically, you can lose more than 100%

It is point number 3 that scares people too much to go short, that you can lose more than 100%

I do not recommend shorting as a long-term strategy.  That is, if you are a long term investor, I think shorting is a bad idea because you are fighting inflation, fighting the productivity of mankind, and most importantly your upside is capped to 100%

However if you are a newcomer looking to getting into swing trading, shorting is something you should probably learn how ot do.

 Theoretically you can lose more than you risk.  How?  If you short something at $10, and it goes to $30, that's how. 

But how likely is that to happen?

Never, ever short a penny stock or a biotech company (even though it is near impossible to do so).  These companies can get bought out or the very low share float can have the price explode easily.

But look at the history of how stocks move.  Stocks move up slowly for a long period of time, and then when they fall, they fall much faster than they rise.  Staircase up, elevator down.Your broker will close your position long before you lose more than you have.

If you short the S&P, it is not going to go up 100% overnight before the broker can close it out.

What about large cap companies?  Think about this one. What is more likely...a large cap company more than doubling overnight, or a company being unraveled as a fraud or filing bankruptcy overnight?  Look at enron, or the banks in 2008...thoe stocks fell FAST...have you ever seen a large cap company rise that fast?  No way.  Maybe a small cap, or even a midcap.  But GE isn't going to double in a week.For these reasons I actually think going short is a SAFER short term strategy than going long, even if I don't think returns are as good, I think there is a better chance of not getting stopped out 10% worse than where your stop was.

Long term investors need not short.  But short term traders need to not be scared to do it if they want to be successful.  The risks are overstated as long  as you stay away from small stocks.

Shorting is hard, and there has to be a very, very good reason to short, but don't be discouraged if you want to learn how to do it. 

12 Comments – Post Your Own

#1) On March 15, 2013 at 12:45 AM, HarryCarysGhost (99.76) wrote:

Hey Valy I was somewhat curious as to how your short of the dow to - %1 turned out. I was following it all week even though I normally don't pay attention to short term macro moves.

Did you let it ride, or were you forced to cover?

I'm not busting your balls man, just want to know how it works.

Cheers.

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#2) On March 15, 2013 at 12:58 AM, redvan (< 20) wrote:

Hello Valyoo,

Covering yourself with call  options (assuming you're shorting in lots of 100) is much safer than counting on your broker to close out your position before your account is out of cash. If the stock moves significantly against your short, you can exercise the calls.

Redvan 

  

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#3) On March 15, 2013 at 1:49 AM, Valyooo (99.63) wrote:

Well I shorted 10 dow futures contracts, and I hedged by selling 15 puts that expire april 19th at 14200 strike, so I am currently down on it, but I am "covered" as long as the dow futures dont move up another 80 points before april 19th.  if it moves up less than 80 points before april 19, I make some money.  If it falls to 14200, I make 20-25% on my portfolio...if it goes 80+ points higher and stays there, I am in some trouble...if it goes another 80 points higher I am going to double my position because that was my upper trendline target....if it moves significantly more than 80 points I am going to have to put a stop loss and probably take a 2-3% loss on portfolio, which would suck...but we will see how it plays out. All I need is a 1.5% dow drop to make 20-25%.  leverage is crazy

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#4) On March 15, 2013 at 12:43 PM, edwjm (99.87) wrote:

I NEVER short in RL, only on CAPS

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#5) On March 15, 2013 at 1:47 PM, JaysRage (90.49) wrote:

I would argue that your choices are more plentiful if you choose to short instead of going long.   When people think of the stock market, they normally talk about indexed stocks....stocks that have been identified as stable enough to be added to a particular index.  Those indexes go up over time due to inflation and productivity increases.   However, this creates a misunderstanding that most companies are successful.....or even that most publicly traded companies are successful....which is a horrible, horrible misunderstanding of truth.    Most companies fail.   Most publicly traded companies fail.   There is a larger selection of potential disasters than there are stocks that will outperform and index fund over time.   

 

To me, the biggest drawback to shorting is the borrowing cost. You have to pay to use someone else's shares.   That's no fun. That can be reversed by selling extreme out of money calls as a short strategy.    It's not a beginner strategy for sure....it's also not a fast money strategy, but it can be very lucrative for stocks whose implied volatility does not remotely reflect it's actual likely forward upward volatility.    

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#6) On March 15, 2013 at 3:45 PM, anchak (99.86) wrote:

"10 dow futures contracts, and I hedged by selling 15 puts that expire april 19th at 14200 strike"

 

(1) 10*72,000= 720 K odd outlay:Margined

(2) 15 142 April Puts : 15* 0.85=  $1275 =1.28K

 

A 100 Point upward move would mean

(1) - 500*10 = -5000

ie risk covered to about  1275/10 = $127.5 per contract = 127.5/5 ( Multiplier) = 25.5 points for DOW.

If 14200 gets you 25% portfolio return that means

Current DJIA ~14500 to 14200 = 300 points ie

300x5* 10 contracts = $15000

However by my math this put prior to expiry will be worth 1.05 at the underlying price of 14200

 

Which means you take a hit of .20 *15 = $300 possibly immaterial.....

 

So on the downside......you will take the 5000-1275 = 3725 risk - which if 14700 =25% profit means 3725 = 6% risk

 

What am I missing? I would really like to do trades where I have a 25% reward with 2-3% risk -- so kindly help me.

ie - a  0.7% up day for Dow - means you take a 6% hit on the portfolio - and if that's your stop - it can easily happen intra-day and THEN Dow gives your 300 points......

Best

 

 

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#7) On March 15, 2013 at 5:39 PM, awallejr (82.72) wrote:

You also need to point out that when you short a dividend paying stock you are responsible for paying any dividend.  You can also get nailed hard during a "short squeeze."  For non professionals I suggest buying puts instead of short selling.  And with puts it is best on stocks that have decent option liquidity so you don't get nailed on wide bid/ask spreads.

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#8) On March 15, 2013 at 6:19 PM, Valyooo (99.63) wrote:

ancahk I am trading 10 mini contracts.  5 dollars a point = 50 a point fo 10.  I shorted 15 puts 14200 strike (keep in mind futures trading at about 70 points uner spot) at 114 points each which comes out to 171 points of protection per contract.  14364 (my entry) + 171 = 14535.   The delta is 0.33 per contract but I am short 1.5 put per contract so it is roughly .5 of exposure Those futures currently trade for 14433, I still have 102  points before I am no longer covered by my puts.

If dow falls to 14200 (or below, my gains are hedged below that) , I will open 5 more short contracts at 14337 so I have no tail risk and I will make 114 + 165 = 279 points x 75 points a contract   is 21k, I am doing this in a side 100k portfolio, so my math was off, it is a 21% upside.  If it does not fall I do not open the other 5 contracts and I lose 0.34% per point it moves over 14535 before april 19th.  Again that is the futures price, which is somewhere around 14585 in the spot price.  I highly doubt it moves much higher than 14585 by April 19th, but hey, I have been wrong before, and if that happens I can close out my options and rehedge with higher strike puts or average down at 14600 because that is the absolute highest I can see spot going.  If the random truly moved randomly than no single strategy would be better than another in which case my case makes no sense.  I don't believe this to be the case though.  But again, I coul be wrong

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#9) On March 15, 2013 at 6:22 PM, Valyooo (99.63) wrote:

Jay nailed it...index rebalancing is why SPX is not lower.

Awallejr, the stock price falls equal to the dividend paid out, so it is a non-factor IMO....and if you short a stock being a 2.5% yield, even if you short for an entire year are only down 2.5% on that...I never recommend shorting for a whole year.  I do not like buying puts as 80% of options expire worthless and I do not like buying theta.  Short squeezes can happen, but so can long squeezes if there is too much margin used to buy a particular stock. 

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#10) On March 15, 2013 at 7:04 PM, awallejr (82.72) wrote:

Except you still have to come up with the cash and oftentimes the stock rebounds after having the dividend payout factored ex-div day.

I do agree that with puts you are paying a premium unless you go deep into them, but then deep puts tend to be less liquid. 

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#11) On March 15, 2013 at 7:13 PM, awallejr (82.72) wrote:

You have to pay to use someone else's shares.   That's no fun. That can be reversed by selling extreme out of money calls as a short strategy. 

In 2008 a day before option expiration I was tempted to sell a bunch of 50 point out of the money calls on Google.  I almost pulled the trigger but knowing they were announcing earnings after the close what if the earnings were great.  Well they announced great earnings and the stock jumped 65 points almost immediately. 

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#12) On March 18, 2013 at 1:21 PM, JaysRage (90.49) wrote:

awallejr -- That's why I sell extreme out-of-money calls.   The risk is far lower.   You're basically taking the position that there is no way that stock gets to the mark you choose by the time of expiration.    If you're right, you pocket the cash.   If you're really right.....you pocket the cash more quickly as the option approaches zero, and you take back your capital to use somewhere else.    By selling calls, time decay is on your side. You can increase your risk/reward by choosing options whose implied volatility is out-of-whack.  

 

In the case of Google, you would have been better off playing both sides and essentially betting on volatility if a big move is almost guaranteed.   That's not my cup of tea, but there are people who make a killing on that kind of thing.  

 

 

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