by Amit Kumar
In contrast, if you had shorted 100 shares of X stock at $120, the notional value of the short investment is $120 × 100 = $12,000. Your broker will typically retain the entire proceeds and may require you to keep 30 percent (or $3,600) as initial margin, depending on regulatory requirements. In this case, your return will be lower at 41.67 percent ($1,500 on $3,600).
However, what if X stock went up $15 or $30, or doubled? The risk seems unlimited here as compared to the limited risk of losing the premium when you buy puts. Buying puts seems like a better proposition in this case, but not always. The price of a put option (or premium) depends on many factors other than the stock price.
The premium for a put option also depends on the volatility, time period, prevailing interest rates, and strike price (the price at which you want to sell the stock). Volatile stocks will demand higher put premiums, and a six-month option will be pricier than a three-month option. A higher strike price (the price at which you would like to sell the stock) will demand higher premiums.
Higher premiums resulting from such factors increase the cost of investment. On top of this, the stock must fall by the value of the premium before the put expires to break even on the trade. Because you can lose 100 percent of the premium on bad trades, a string of bad trades can severely cripple your portfolio.
Closing the Short Trade
In the absence of margin or borrowed money, cash equities holders can theoretically hold onto their stocks forever. However, short sellers can be forced to close their positions in the face of adverse events—lender calls, regulatory restrictions, short squeeze, and margin shortfalls, to name a few.
It is important to understand that the lender continues to be the owner of stock that they lend the short seller to short. It gets a little trickier after the short seller sells the stock, because we now have a second owner of the stock. For example, if 20 percent of a company’s outstanding stocks are sold short, 20 percent of the stocks are held by the lender, and another 20 percent is held by the new owners who bought these shares from the short seller. Thus, short selling in this case lowers the float (stocks available to trade) from 100 percent to 60 percent (100 percent minus 20 percent minus 20 percent).
Does it get more complicated if the founder or a strategic owner has a 60 percent stake in the company? It not only becomes trickier but extremely risky for the short seller, because the float now lowers to 0 percent (60 percent minus 60 percent). Even if a small percentage of the lenders decide to recall their shares, they can squeeze short sellers, forcing them to find and buy back shares. Positive stock news can also force short sellers to cut losses and cover their position
BUYING CALLS IS A SHORT SELLER’S INSURANCE
Buying a call option allows you to lock the stock price at the desired price (or strike price). The buyer pays a premium for this price insurance, and gets the right to buy the stocks at the strike price in the future. Such insurance can be a lifesaver for the short seller, should the shorted stock keep rising.
How Does a Call Option Work?
Suppose you have shorted 100 shares of X that is trading at $120 per share. You fear that any positive earnings or new acquisition announcements by X can drive up their shares by $10 to $20. You do not want to cover your X stock; however, you want to protect your losses in the event the stock rises. In other words, you want the (call) option to buy X at $120 per share over the next six months if X stock rallies. You decide to buy such an option at the prevailing market price of $2 per share or $200 for one contract (one contract is usually based on 100 shares).
A few months later, X is trading at $135 and you lose $15 per share on your short position; however, your call option compensates for this loss by allowing you to buy X at $120 per share. Alternatively, you can decide to keep X short and sell the call instead for a premium of $15 per share ($135 minus $120). Had X traded below $120 per share, you would have lost the $2 premium.
When you buy a call option, your maximum loss is the premium paid, similar to a put option. The returns on a call option can be multifold. For example, you made $13 per share on a $2 per share put option (a whopping 6.5× or 650 percent return). In contrast, if you had bought 100 shares of X stock at $120, your returns will be lower at 12.5 percent ($1,500 on $12,000).
Call Option Versus Shorting
Selling a call option is somewhat similar to shorting stocks because you are betting that the stock price will not go up. In the previous example, you collect a $2 premium when you sell a call option and you can keep this premium if the stock does not rise above $120. However, if X rises to $135, you lose $13 per share.
When you sell the X call option, your maximum profit is the $2 premium collected, even if X stock falls by $10 per share. In contrast, a short position stands to make a profit of $10 per share in this case.
Duration or Holding Period of Shorts
Due to the callable nature of a short trade (the lender has the option to recall their shares), adding short positions to a stock portfolio lowers the duration or holding period of the portfolio. An untimely recall on the shorts can lead to unwanted losses. While it may be difficult to eliminate this timing risk, the right short position size (less concentrated positions) can mitigate the size of the loss.
Investment Hurdle Rate and Payoff
In the absence of margin, the investment hurdle rate for a stock is zero or its benchmark index. However, short investments have an investment hurdle rate of at least the borrowing cost and the stock dividend yield in addition to the fund benchmark. Short-only funds can invest the cash proceeds from the stock in the fund benchmark or the market to eliminate benchmark risk.
The payoff for short investments is almost the mirror opposite of long investments. The maximum upside for a short idea and maximum downside for a long idea are 100 percent. Conversely, the maximum downside for a short idea and maximum upside for a long idea are theoretically unlimited. In Warren Buffett’s words, “You can’t make big money shorting because the risk of big losses means you can’t make big bets.”2 Short interest may be only one side of the story.
Short sales may not necessarily be motivated by a bearish opinion on the stock. Pair trading, arbitrage, and market-making activities also constitute a large part of short trading volume and short interest. It is nearly impossible to get insight into the long counterparts of a short leg for these trades. For example, if a money manager discloses that he or she is short on a copper stock, it is hard to tell if the money manager is hedging homebuilder stocks or bearish on copper.
Lack of Disclosure on Who Is Short on the Stock
Short interest statistics indicate the level and change in short activity for a stock, but not the players behind the short bets; however, prominent short sellers often reveal their short positions. On the other hand, stockholding reports provide more color on the stock owners, their level of holdings, and recent changes to holdings (table 11.1).
Table 11.1
Google short interest
Source: Bloomberg.
Tax Treatment Is Mostly Short-Term Gain or Loss
Short sale gains and losses are treated mostly as short term, but they can sometimes be treated as long term based on the amount of time the stock is held before it is delivered to the lender to close the short trade. Tax treatment of dividends paid on shorts is subject to holding period requirements, which can restrict you from deducting dividends paid on short positions held for less than 46 days but allow you to increase the basis of covering stock.
Takeaway
Shorting is different from buying stocks in many respects, including the mechanics, tax treatment of potential profits or losses, and hurdle rate.
Common Types of Short Equity Funds
Common types of short equity funds include the long-short hedge fund, short-only or short-biased fund, 130/30 long-short mutual funds, and short and ultra-short exchange-traded funds.
Shorting Is Not for Everyone
The discipline of short selling is not suited for a
n average individual investor; it is geared more toward institutional investors with sophisticated research and risk management resources.
Hedge funds dominate in short strategies and their charter mandates them to short stocks. They offer both short-only and long-short products. Mutual funds and exchange-traded funds (ETFs) that traditionally offered long-only products have begun offering long-short funds (e.g., 130/30 or 150/50) and short-only ETFs in the last five years.
Short sellers are up against many factors: asymmetric returns, squeeze risk, short-term capital gain treatment, and borrowing costs, among others. Their interests often clash with everyone in the market—promoters, Wall Street analysts, renowned investors, and even regulators.
So, what is the motivation for institutions behind shorting? Good shorting strategies promise to protect downside and potentially deliver positive returns, allowing money managers to generate positive returns—even during bear markets.
Recap
• Shorting involves borrowing stocks in order to sell short.
• Borrowing makes shorting risky because the lender can force you to cover (or close) your position on short notice and force you to realize losses at an inopportune time.
• Derivatives, such as options and futures, offer alternatives to stocks or cash equities. Puts are the most common derivatives used for shorting.
• Buying puts is akin to shorting stocks. Buying calls lowers the risk of shorting stocks by providing protection against a surge in stock price. Selling calls is a poor substitute for shorting.
• Short squeezes are the single biggest risk for short sellers.
• Shorting is different from buying stocks in many respects: mechanics, potential profits and losses and their tax treatment, and hurdle rates.
• Shorting is geared toward institutional investors with sophisticated research and risk management resources.
• Long-short hedge funds, 130-30 mutual funds, and ultra-short ETFs are the most common investment funds that short stocks.
Glossary
ADJUSTABLE RATE MORTGAGE (ARM) Mortgage with a fixed rate for an initial period, which can be two years, five years, seven years, or ten years. Mortgage rate resets to floating rate at the end of the initial period of fixed rates.
AVERAGE REVENUE PER UNIT (ARPU) A commonly used key performance indicator (KPI) in the telecom industry for revenue generated from the sale of one cell phone.
ASSET-BACKED SECURITIES (ABS) ABS security is derived from securitization of assets such as car loans and credit card receivables. (See Securitized product)
BLACK-SCHOLES PRICING MODEL Companies use this popular mathematical model to price European-style derivative instruments (e.g., employee stock options, warrants, and convertible bonds).
CATALYST Events or news that can trigger a positive or negative reaction to the stock price. Investors and analysts like to identify and watch catalysts (earnings, product launches, restructuring, management changes, monthly retail sales, capacity expansion, etc.) to time their buy or sell decisions.
COLLATERALIZED DEBT OBLIGATIONS (CDO) A subset of asset-based securities (ABS) that can be based on loans, bonds, commercial real estate, structured products, or synthetic obligations from derivatives, such as credit default swaps and other CDOs.
COMP STORE SALES (also referred to as comps, comp sales, same store sales, like store sales) Typically refers to the revenue growth for stores that have been open for a year or more. Many retail companies report comp store sales on a monthly basis, and some report on a quarterly or annual basis. Comp sales is a closely watched number for retail stocks.
CREDIT DEFAULT SWAP (CDS) CDS instruments allow investors to short bonds with limited downside, just like put options on equities. CDSs are identical to insurance contracts on bonds or loans that are issued by corporations or sovereign entities. A CDS contract holder pays a fixed premium to the seller, and the seller agrees to pay the face value of the loan or bond if the issuer defaults. An issuer default may not necessarily mean bankruptcy or insolvency, but it can trigger a credit event when the bond issuer fails to meet certain loan service conditions or indentures (e.g., failure to pay interest or maintain a certain ratio of profitability in relation to its obligations).
A CDS is an over-the-counter (OTC) financial instrument traded mostly by institutional investors and investment banks. A typical contract may be based on an International Swaps and Derivatives Association (ISDA) Master Agreement and customized to specific investor needs. CDSs were launched in the 1990s, but caught public attention during the financial crisis of 2008.
CDX An index of CDSs similar to the S&P 500 index for stocks. CDX can be based on investment grade credit, high yield credit, or other credit securities. CDX and ABX (an index of subprime mortgage-backed securities) came to prominence during the financial crisis when a handful of investors made successful short bets on these indices. CDX and ABX can provide insurance protection on credit instruments.
CYCLICALITY The correlation of company sales to expansionary or recessionary cycles of the economy. Once economic recovery begins after an economic recession, early-cycle stocks such as financials tend to recover first, followed by mid-cycle stocks such as industrials, and then late-cycle stocks such as materials and energy. Defensive stocks such as utilities and consumer staples tend to outperform during recessionary phases.
D/E (DEBT/EQUITY) AND D/C (Debt/Capital) D/E is the ratio of long-term liabilities to the book value of equity, and D/C is the ratio of long-term liabilities to total capital (liabilities + equity). D/E or D/C indicate the indebtedness of the company and are also called leverage ratios. Leverage ratios and debt service ratios are important indicators of indebtedness of a company.
DAYS TO COVER The number of days it would take for all short sellers to cover their positions; the calculation is based on the average trading volume of the stock. If average daily volume of a stock is 3,000,000 and the number of shares sold short is 6,000,000, it would take two days to cover the entire short position. Days to cover is also called short ratio.
(DEBT + CAPITALIZED LEASE)/EBITDAR When a company has long-term operating lease contracts, debt/EBITDA does not depict its true ability to service the debt. In such a case, debt can be adjusted to include the capitalized lease and rental expense can be added back to EBITDA. Analysts typically use 8× rental expense as a proxy for capitalized lease. A debt/EBITDA ratio below or close to 1 can be an alarming signal.
DISCOUNTED CASH FLOW (DCF)/NET PRESENT VALUE (NPV) DCF and NPV techniques project future cash flows of a company and discount them to the present value to determine the value of the stock. This discounting technique is based on the concept of the time value of money; i.e., the value of a dollar today is worth more than a dollar tomorrow. DCF valuation rests on two critical assumptions: (1) revenue and earnings projections, and (2) discount rate or cost of equity. PV10 is a commonly used DCF valuation technique in the oil and gas industry where cash flows are discounted at a fixed rate of 10 percent.
DIVIDEND DISCOUNT MODEL (DDM) Projects future dividends of a company and discounts them to the present value to determine the value of the stock. This model is used for mature companies with a long history of dividends.
Earnings per Share (EPS) A closely watched number and strong driver of stock prices. EPS = net income/shares outstanding, and is also known as basic EPS or trailing EPS (net income for the trailing one year is used here).
Diluted EPS calculation adjusts shares outstanding for any dilution from issuance of employee options, warrants, etc.
Forward EPS = consensus net income/shares outstanding. Consensus net income is the average net income for the next year or future years as estimated by Wall Street analysts.
Normalized EPS = normalized net income/shares outstanding. Net income is normalized to eliminate one-time charges or extraordinary items.
EV/EBITDA Takes overall debt, cash balance, and minority interests into account and ignores depreciation and amortization as operating costs.
It is a commonly used valuation multiple in capital intensive and leveraged industries.
EV/(EBITDA–CAPEX) Depreciation and amortization are non-cash expenses based on a company’s estimated life of the related assets. Companies assume the value of an asset goes to zero or a salvage value, and expense that value as depreciation costs over the asset’s estimated life. However, some or most of this depreciation cost may be real since companies need to make capital investments every year. Companies may seem cheap if the EBITDA is not adjusted to reflect these investments (or Capex). EBITDA-Capex adjusts for recurring investments to provide a better measure of operating profitability for industrial companies or hard asset intensive companies.
FILINGS The Securities and Exchange Commission (SEC) is a primary regulator for U.S. stocks and mandates companies to file certain forms periodically to disclose material information (information that is highly likely to impact stock price).
FLOAT Shares outstanding that are available to trade. Stock with 40 percent float means 60 percent of the stocks are closely held by insiders, institutions, etc., and are not available to trade in the public market.
FREE CASH FLOW (FCF) MULTIPLE OR YIELD Free cash flow is defined as net operating profits after tax (NOPAT) + depreciation and amortization (D&A) minus change in net working capital minus capital expenditures. FCF is excess operating cash generated by the company after capital expenditures. FCF yield = FCF/market cap and FCF multiple = market cap/FCF. Companies can use FCF to buy back shares or pay special dividends. In theory, a company trading at 20 percent FCF yield or a 5× FCF multiple (1/20) can buy back all its shares in five years. High FCF yields indicate that the stock is trading cheap but can often also lead to value traps.