What are some of the best techniques for selecting stocks to short?

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What are some of the best techniques for selecting stocks to short? by Laurent Bernut

Answer by Laurent Bernut:

Two parts: let’s start with stuff that does not work and end with stuff that works.

Part 1: stuff that does not work

High short interest:

Short interest and/or borrow utilisation is a function of supply and demand. Supply of stock available for borrow and demand from short sellers. So, when short interest rises, it means two things:

  1. Supply is drying up: institutional long holders liquidate their positions. Remember that whatever information that has led You to conclude something is a short is also available to long holders, who probably conclude it is not worth holding anymore
  2. Demand from short sellers is increasing: unlike going Long, going short is a finite universe. There is a limit to the amount of shares available for borrow. So, You will end up competing with short sellers and stable shareholders, those who never sell

Analysts downgrades:

Analysts are chronically late to the party. It is difficult for them to downgrade their ratings, especially when the whole investment banking food-chain depends on them rating stocks as Buy. Example: Enron was rated Buy days before its collapse.

Bottom line, You don’t need analysts in Bull markets and You don’t want them in bear markets

Fundamental newsflow deterioration:

Many market participants wait for deterioration of fundamentals before putting on a short. Well, if You believe that markets are discounting mechanisms of future events, waiting for the confirmation of those events is by definition late. This is called confirmation bias.

On the short side, it often comes from painful experiences. Market participants often start with anticipation shorts: unsustainable valuations, momentum etc. They get carried out a few times. So, their next move is confirmation short: wait for fundamentals to really suck before putting on a trade. They then compete with other fundamental short sellers.

Vigilante short selling

Tourists short sellers often short stuff that does not make sense anymore. They go after crazy valuation, parabolic momentum etc. They may be right in theory, but they are invariably wrong in practice. One sane person versus an irrational mob is still an unfair fight.

Personally, i have no sympathy for those market participants. They put other people’s money in harm’s way. Their egos breach their fiduciary duty to their clients. Luckily, they don’t hang around for too long

Part II: stuff that works

Momentum:

Between the time a stock should go down because valuations & momentum are unsustainable and the time when a stock should go down because fundamentals are horrible, there is a long period of time when price actually DOES go down. Reality is the time between the “should”

Look for downward relative momentum first, then weave whatever rationale You want.

“Buy” for the long term investor

My favorite of all times is a blind spot of analysts. Within their coverage, there is always a buy rated stock that performs poorly. They call it “Buy for the long-term investor”, meaning short term it will go down and You have to be patient.

So, as a good acid test, thank the analysts for the info and ask them if they would like to be paid long-term commissions for those long-term ideas. If they grimace, then Short

Relative Shorts

Before Valeant (VRX), Wells Fargo, Deutsche Bank, Lehman Brothers, Enron drilled a hole in the earth’s crust in absolute, they underperformed their benchmark for some time.

Relative momentum (Absolute Price / Benchmark price) is by far the surest way to find good shorts. a good Long/Short portfolio is composed of Long book of outperformers and a Short book of underperformers.

Putting everything in relative terms will immediately increase the number of short ideas.

What are some of the best techniques for selecting stocks to short?

Should naked short selling be illegal?

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Should naked short selling be illegal? by Laurent Bernut

Answer by Laurent Bernut:

Let’s leave the adorable legal answers from “investors” aside for one minute and let’s think about what would happen if naked short selling was legal

A. Price discovery and price equilibrium

Many issues are un-shortable because there is no borrow available. It is a bit like artic ice. They slowly melt away until they liquify real precipitously.

The ability to short w/o having to source borrow first, would hasten price discovery. At some point, buyers would meet sellers, and there would be price equilibrium.

Short sellers facilitate price discovery

B. Transaction cost, volatility and market impact

In 2012, There was a landmark study on the impact of short selling done by the New York Fed. Long Buyers could only buy from a Long sellers. Bid/ask spread widened. The ban on short selling financial services materially increased transaction cost, volatility and reduced liquidity. Short selling has a net positive impact on transaction cost

Short sellers provide liquidity

C. Hedging

Not all short sellers want the underlying companies to bite the dust. In fact, only the emotional short sellers with a distorted sense of fairness do.

People sell short for all kinds of reasons. If You cannot sell short, you cannot hedge, Therefore, you cannot underwrite products such as options, futures, CBs. Now, there is a natural limitation coming from the borrow available. Put/cll parity goes out of whack for hard to borrow issues

Short selling provides better pricing on derivatives

D. What would happen if You sell sth You do not own?

Regardless of whether You sold naked or covered, you are still liable for the difference between the selling and the buying price. There is no way your broker will forgive your losses. So, what’s the problem here? the ability to drive prices into the ground, fairness, moral high ground,

In theory, if You do not need to own a stock, then You could short ad infinitum and potentially drive prices into the ground. Reality check: this happens … on the Long side. People do buy something they do not own yet. Does it drive prices to the moon? No, there is equilibrium between buyers and sellers

Now, naked short selling for the purpose of hedging other instruments such as derivatives is a different issue. Put underwriters delta hedge

As for fairness, put yourself in the shoes of a short seller for one second. More often than not, You are denied the ability to short an issue simply because there is no borrow. Borrow comes from LT large shareholders and institutions lending their shares. So, you are at the mercy of people who may decide not to lend or even recall their stock at anytime. Meanwhile, buyers are not at the mercy of anyone if they want to buy a stock. So, who is treated unfairly now?

The only two ways to live your life: Hero or victim

People who complain about short sellers are usually disgruntled righteous “stock pickers”. They get into some stock, which immediately proceeds to go Valeant on them. Then, they blame short sellers from driving prices down. One thing they need to know, borrow available is less than 10% of daily volume on average. So, yes someone is selling big time, but not the short sellers. Think about this next time You see a stock tanking: for every smart investor who has bought the stock, there is a smarter investor liquidating now. Just ask yourself Why

More importantly, there are two ways to live your life. Either You are the hero and triumph over adversity. Either You are the victim of circumstances, evil speculators, the system, the government. when people blame short sellers, they obviously take the role of the victim.

Now, if You were a pension asset allocator with money to deploy, who would You trust?

  1. someone who acts as a heroin and assumes responsibility for her mistakes or,
  2. someone who plays victim and blame everyone else for his lousy stock performance

Think about it next time You blame short sellers. Unlike underperforming “investors”, Short sellers do provide vallue

Should naked short selling be illegal?

I need your help: what are your three favourite book covers for the book “The Virtue of Short Selling” ?

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This is an exciting time. The book is taking shape. It is now time to choose a cover. You will get to participate in the making by ranking your 3 favourite covers in descending order. The cover that will have the most votes will be selected. Also, if You have suggestions, please do not hesitate. This is a democracy. This book is meant for You, to help You on your journey on the markets. Help me help You

So, i would like to ask a little favour from You.  Would You be so kind as to rank covers ? There is GoogleSheet. It will only take less than 5 minutes of your time, but will be immensely helpful.

  1. Imagine three situations:
    1. You are flicking through Amazon bookstore or an airport bookstore. Which cover would catch your attention?
    2. What cover best represents you expectations from this book
    3. You recommend this book to a friend/colleague. What cover would be best?
  2. Next:
    1. Clink on the link: The Virtue of Short Selling scorecard (If the link does not work, a simple rank would still be really helpful)
    2. Fill out the cells. There are already pre-existing examples
    3. Share it back to my e-mail: laurent.bernut@alphasecurecapital.com or info@alphasecurecapital.com

Participants will get free bonus gifts and my eternal gratitude

 

Theme: Rope Walking

The red line is a stock chart successively bull and bear, while the upward sloping  represents the equity curve. Tight rope symbolises the delicate balance of managing riskthrough Bull and Bear alike. At the end of the day, “Bull, Bear, it all tastes like chicken”

  1. Rope Walker Green Manhattan

2. Blue Rope Walker Manhattan

3. Blue rope walker through the clouds

Bull/Bear Dichotomy

The Bull bear dichotomy symbolises both opposition and unity. Bear morphes into Bull and vice versa

4. Bull Bear Red/Brown

5. Bull/Bear Green/Brown

  • Tarot card: The Chariot

Tarot cards date back to the Egyptian civilisation. They carry deep subconscious symbolism. The chariot is powerful card that symbolises progression, strong character, success from effort. A Bull and a Bear pull the chariot. Loose reins symbolise relaxed quiet strength

6. The Chariot from illustrator Valentin Boogaerts

7. Triumphant Chariot

  • Other themes

8. Orange pictogram

9. School book cover

  • Animal Themes

10. Saint Rabbit

11. Running hare

 

 

 

Is short selling bad for your psyche?

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Is short selling bad for your psyche? by Laurent Bernut

Answer by Laurent Bernut:

“Lo que no mata engorda”, what does not kill you makes you fat. Bob Baerker, a respected short-seller, sums it well.

You are probably alluding to the good and evil battle between the righteous short seller who perceives wrong, the arrogant and corrupt management who falsify their financial statements and price that stubbornly goes up until the final collapse.

Fairness will kill You

Fairness is one of the very few built-in traits in humans. Numerous studies have been conducted on fairness in toddlers. It appears that our sense of fairness predates our language. Even children who turned out to exhibit clinical psychopathic tendencies, dysfunctional amygdala, react to fairness.

So, as short sellers, every now and then, we are tempted to right the wrongs. We engage in a duel with companies and the multitude who buy into the frenzy. One sane mind against a raging mob is still an unfair fight.

A simple advice is to wait until the mob has changed side and starts liquidating its position. You will be vindicated.

Short selling: the spinal tap of investing

Stress volume always at 11

In spinal tap, they can turn the volume at 11. On the short side, stress volume is always at 11, even when it works in your favor. In that sense, short selling is corrosive for your psyche until You learn to manage stress.

It takes time to get there but here are a few techniques that will help You:

  1. Plan your exits: the short side is a bumpy ride. I used to maintain between 40 to 60 shorts at all time. That’s a lot of bumps. It all changed when i set up hard exit rules. Having hard rules for exit is a tenfold reduction in stress. All my Long Only colleagues were glued to the newsfeed to guess what to do next. Meanwhile, as nothing flared up, i was left watching spiritually awakening and highly educational content on Youtube
    1. partial exit: take risk off the table as a short squeeze starts. No-one knows how far price will retrace and gains evaporate, so reduce size
    2. stop loss: never enter a short w/o a stop loss. Never override stop loss. No exception
    3. reversal: there are quite a few false positives. Sometimes, shorts turn into Longs before they trigger a stop loss. Do not ignore what the market is telling you. Market is right, or it can afford to stay wrong, you can’t
  2. Quantify your risk: risk is not a story in the US, China or wherever. Risk is a budget: how much you can afford to lose and keep trading. Accept you could lose that much because:
    1. This is called pre-mortem. It actually releases endorphine and facilitate recovery. The quicker you can put a bad trade behind you, the quicker you can focus on the next one
    2. More often than not, you will lose. Quantification helps you get better at money management
  3. Practice mindfulness: every other spiritual guru talks about mindfulness. In its simplest form, it is the ability to observe what is happening without being sucked into the emotional roller coaster
  4. Welcome to the dark side: the short side will test the darkest corners of your psyche. It will go and elicit fears so deep you did not know you had them. Great, fear dissolves when exposed. I used to journal fears and work through them using Byron Katie’s The Work. Van Tharp recycled this in his fantastic “trading beyond the matrix”. Fear elicitation is a great tool to help you work through your subconscious phobias.

Conclusion

Viktor Frankl, who happened to have survived Auschwitz and Birkenau, said between stimuli and response there is something called freedom. You have the choice of how you will respond. So, fear happens, losses mount. How you choose to deal with them is your path to emotional freedom

Is short selling bad for your psyche?

I’m good at shorting, is it possible to start a short biased hedge fund?

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I’m good at shorting, is it possible to start a short biased hedge fund? by Laurent Bernut

Answer by Laurent Bernut:

Excellent answer from Bill Chen, to which there is little to add. In my opinion, short-selling is widely misunderstood even by professional sophisticated investors. To add insult to injury, FED and ECB are the official sponsors of the longest bull market on record.

Short-sellers are like sharks…great-white-shark-sharkspictures.org_

Did You know that deep in the quiet comfort of your house, there is something 150 times deadlier than a shark ? It is called a bed. The probability of dying after falling out of bed (literally) is 1/2*10^-6, while ex-sanguination from an exploratory shark bite is 1/150*10^-6. Sharks are misunderstood and fragile. So are short sellers.

Adding a short component to a long strategy reduces volatility of performance, increases leverage and reduces drawdowns in terms of magnitude, frequency an period of recovery. Now, this is neither how they are perceived nor marketed.

They are perceived as predatory, nefarious and risky in nature. I lost half of my pension in 2008 to supposedly buy and hold low risk mutual fund #de-friendBuy&Hold.

Short biased funds are relative players, just as your average mutual fund. Their benchmark is just the inverse of the index. When the market goes up by 10% and they clock +8%, effectively they have outperformed. The only problem is that investors lose -8% in absolute. No-one likes to structurally lose money, right ?

Wrong, 3/4 of mutual funds trail their benchmark year in year out. Investors make money in absolute but lose versus index funds. Worse even, mutual funds lose both in absolute and relative during bear markets. So, here is an interesting perception gap:

Short biased funds lose money during bull markets but make some during bear markets. Rationally speaking, they serve a more important purpose than mutual funds. Logically speaking, you do not need a mutual fund, but you do need a short biased fund in order to protect you from downturns.

The problem is that most of them will have died by the time we hit a bear market. The second problem is that short selling is still perceived as evil, when all they do is provide hedge in good times and absolute performance when no-one else does

BTW, small difference of opinion with Mr Chen, redemptions do not come during outperformance during bear phases. They come during early bull markets, when bearish sentiment as well as AUM peak. Short funds handle regime change quite poorly. The same happens with Long Only. Managers can underperform and still grow assets in bull markets because everyone makes money. Long Only underperforming in bear markets is bad…

Prometheus and capitalism

Monetary authorities around the world have mutually decided that bear markets are bad. So, they play god with the markets. They do whatever they can to prop them up. Their latest trick was a sucker punch to the very foundation of capitalism: negative interest rates. In what parallel universe does it make sense for a borrower to be paid to borrow money ?

This begets an interesting question: if they are blind enough to think they can tame the markets, will they be competent enough to solve the problems they have created ?

Anyhow, the point is the only trade in town is: when a tired bull market wants to go down, buy everything and wait for the monetary cavalry to show up with their QE heavy artillery.

This market manipulation is damaging for all market participants. It rewards complacency and bad behavior on the long only side (double down on losers) and wipes out short sellers. In March, i lost -15% in 3 weeks. This bull is tired but central bankers will not admit it until …

What’s the solution then ?

Once upon a time, mortgage bonds were boring. Then, someone figured out a way to package and MARKET them as low risk / high yield investment securities. Shortly thereafter, every other math wiz kid and smooth salesman became fluent in CDO linguo.

Same with short selling. As long as we are the “usual suspects” and default scapegoats for markets falling, speculation, corporate greed, obesity, erectile dysfunctions and all other evils on earth, small or large, then AUM will have wild swings. Picture a young promising executive pitching a short fund during an investment committee Monday morning 9 am

-“ things look a bit dicy here, i would like to start allocating to a short biased fund”, says the newbie

-“sure, buy a dividend fund or allocate more to government bonds funds”, replies the chairman

-”3% dividend is not going to cushion much when the market goes down -50%. Actually, government bonds are the reasons i am getting a bit nervous”, replies the young man

-”Now young man, how do you think our investors will perceive us if they know we are buying a short fund ? They will think we have no confidence in our economy. They will cease to see as patriotic, hard working, disciplined investors, prudent risk managers. They will think of us as short term traders, evil speculators. Rest assured they will redeem”, slams the chairman

-”You are right sir, but our clients will redeem anyway if we lose them money. Short sellers are just as patriotic, hard working and probably more disciplined than Long Only. Short sellers just happen to make money when no-one else around does. At least, if we make money for our clients, we have a chance to keep them. If we are one of the few who make money during downturns, maybe we could even grow assets. Look at Mr Paulson”, whispers the newbie as he shrinks and recoils away

-”You are a bright and talented young man. May i suggest a bit more optimism and team spirit for the rest of your career ?”, concludes the chairman with a paternalistic threat

The reason why John Paulson’s AUM exploded is: he made money when no-one else did. He stood out as a clear winner in a crowd of losers. Short selling is the most important and most valuable skillset. It just has bad press and needs to be repackaged.

Speaking of which, I am writing a book about short selling. 3/4 done already. It is about trading edge: statistical, mental and portfolio construction

I’m good at shorting, is it possible to start a short biased hedge fund?

Can the Quant Meltdown of August 2007 repeat again in the future?

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Can the Quant Meltdown of August 2007 repeat again in the future? by Laurent Bernut

Answer by Laurent Bernut:

This is an excerpt from the book i am writing on Short sellingimplosion

Start with the Shorts in mind

In August 2007, cross sectional volatility took all markets around the world by surprise. Indices did not move much in aggregate, but constituents jumped and crashed 2-3% across the board for two days. Then, rumours of quants funds, such as Goldman Sach’s flagship market neutral unwinding, started to spread. This was the beginning of the end for quantitative market neutral funds. Their short books were the culprits.

Leverage
Quants had built those models where they had an arbitrage Long good / Short poor quality stocks. Since they were market neutral, the cash proceeds from short selling could be used to leverage up almost ad infinitum. Some funds were levered up 7 times. Leverage was used to magnify otherwise underwhelming returns.
Quality was working well on the Long side. All they had to do was match exposure on the short side. They had to continue short selling in order to match the natural expanding Long side. It all worked well until volume started to dry up during the summer months.

Liquidity on the short side and chain reaction
They eventually realised it would take them weeks to unwind their short positions. So, they proceeded to pare positions down to manageable liquidity. Since everyone with roughly the same models came to the same realisation around the same time, it triggered a chain that culminated into a messy cross sectional market.

Not so safe after all
Back in those days, market neutral funds were marketed as safe investment vehicles: equity returns with fixed income volatility. When some funds started posting -4 to -8% returns during seemingly quiet markets, investors panicked. Soon enough, redemptions started to come through.
Those redemptions forced managers to close positions, thereby adding more volatility. Prime brokers asked for larger collateral as Value At Risk (VAR) increased, thereby forcing funds to reduce leverage. With reduced leverage, increased volatility and piling redemptions, it was game over for market neutral funds.

Morale of the story
It all started with one simple mistake: in their minds, the short side just happened to be some byproduct of the Long side.
Morale of the story: whatever has the power to kill a business is not a sideshow. The short side may command higher fees and reduce risk, but when neglected it has the power to bring a business down.

This will happen again in the future as long as market participants do not take the dynamics of the short side into acount

Can the Quant Meltdown of August 2007 repeat again in the future?

The short-selling world according to DARP

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Most market participants look at the short-side through their Long Only perspective. They believe that if they apply the same logic that has made their success on the long side to the short side, WorldAccording toGarpthen it should work. It should work but it does not. The Short side is still Terra Incognita, a vast continent populated with savage speculators. It obeys its own rules, its own dynamics. Newcomers to the world of short selling tend to be either too early or too late. Profitable shorts are at least as plentiful as long ideas. Market participants just don’t look for the right clues.
Stage 1: Contrarian shorts: from stratosphere to ionosphere
Market participants often come to short selling from the Long side. They believe in fairness. What is cheap should progress to fair valuation. Conversely, what is expensive should revert to fair valuation. Fairness is one of the very traits that transcends culture, race, and age. Toddlers have deep sense of fairness, long before they can speak. We are hardwired for fairness in a world that is not. Carrying that subconscious belief in the markets is a deadly virtue.
Market participants often see themselves as the lonely voice of reason amidst a delusional crowd. They may be right, eventually, but meanwhile  one single individual battling a mob is still an unfair fight. Stocks that have reached stratospheric valuations often have enough momentum to push to the ionosphere, before gravity reels them back in. Stocks on PE of of 100 have escaped the gravity of reason. They might as well go to 150, 200 or 3000. This is the rarefied atmosphere of permanently high plateau, paradigm change, because like before, “this time, it’s different”
Short selling something that does make sense does not make sense either. As Keynes used to say, markets can stay irrational longer than we can stay solvent.
From a portfolio construction perspective, this does not make sense either. On the long side, market participants expect fundamentals to improve and stocks to go up. They are in for the long haul. Meanwhile, on the short side, they expect imminent collapse. So, they are Long trend following and short mean reversion. Those have diametrically opposed reward to risk profiles. They have different P&L distributions and different sets of risks. Risks that are different do not cancel each other out but compound as they quickly realise. It is always painful to watch a short book accelerate faster than a dull long one.
Once market participants re-acquaint themselves with the old adage “the trend is your friend”, they are scarred enough to move to the next stage.
Stage 2: crowded shorts: the province of fundamental short sellers
The last 5% around the top and the bottom have claimed more market participants than the 90% in between.
When short selling by anticipation fails, market participants turn to shorting by confirmation. They wait for fundamentals and newsflow to deteriorate enough to place a trade. They have been scarred before, so they want every box ticked, every fact checked.
What they fail to realise is that if there is sufficient evidence to conclude that it is a short, there has probably been enough warning signs for long holders to bail for some time.
By the time short sellers have accumulated sufficient evidence to build a short case, long holders have left the building. Short sellers are left battling with one another over a dry bone. Those shorts  make sense, but they rarely make any money.
In fact, the reward to risk curve has inverted. Outcome is binary: either stocks goes to zero, either there is some corporate action: takeover, management change etc. One of my  London ex-colleagues used to say that a distressed stock going from 1 Euro to 50 cents is still a 50% decline. True: 1 to 0.50 is -50%, but only after 6 or 7 nasty short squeezes. The question is not whether stocks will get to zero, the question is will you still be there by then ?
In my time as a dedicated short seller, brokers used to call and pitch “structural shorts”. Structural shorts trigger a deep seated Pavlovian reflex: it makes me want to
  1. buy the stock
  2. graciously offer the borrow for free
  3. and send a box of chocolate to whomever wants to short. Chocolate  is a good therapy for smoothing the rough short squeezes ahead
Stage 3: Frustration and the despair of structural shorts
Contrarian shorts hurt. Fundamental shorts do not contribute much either. At this stage, market participants realise that the beliefs they hold about short selling may be right in theory, but still losing money in practice. Frustration and despair sets in. They have a couple of shorts and “hedge” their portfolios via futures. At that stage, market participants have literally no idea on what and how to sell short.
What happens when we lose your car keys in a dark corner of a parking lot? We go and look for them under a lamp post, where there is light of course. Market participants look for those structural shorts that will go down forever so that they can throw away the key and go back to their longs.
Market participants who publicly profess their hunt for structural shorts are unfit for managing people’s money for two reasons:
  1. Divorce from reality: Structural shorts are like market gurus: they are a dime a dozen. Profitable structural shorts are like market wizards, good luck finding one. Borrow is expensive and long holders have left the building a long time ago
  2. Abdication of responsibility: when they say they want structural shorts, what they mean is they do not want to be bothered with the short side anymore. They want to find something that they can throw in the short book and “forget about it”. This is an implicit acknowledgement of failure. They are happy to collect fees, but reluctant to do the work. There is obviously no hedge, no downside protection, no free lunch and eventually no happy ending.

At this stage, market participants resort to futures. They realise their vulnerability both versus the markets and versus their investors. The problem is futures do not offer much protection when markets tank. Besides, investors are understandably reluctant to pay exorbitant fees for something they can do themselves. They are willing to pay as much

Stage 4: Unplug from the matrix: reality is the time in between the “shoulds”

Between the time when Valeant was puffed up to “unsustainable valuations”, and the first analyst to throw the towel with a “Sell” rating, share price actually did go down by roughly -80%. There was no “beam me down Scottie”, exchange between share price and the deck of the Enterprise. Share price did go down over time, but market participants were institutionally blind to it.

Persistent short sellers one day wake up to the fact that between the time when “valuations should normalise” and when “company should collapse”, there is an extended period of time when share price actually does come down. Reality is the time in between the “shoulds”.
Stage 5: DARP: the un-sexy flip-side of GARP
Under-performing stocks are everywhere. They rarely reach extreme valuations, so they never feature on everyone’s target short list. They just trail their sector, the benchmark and eventually drop in absolute as well. They just slowly fade into oblivion, and this is why we have a collective institutional blindspot. There are three main reasons for this: psychological and wrong assumptions
Analysts color blindness
Analysts are color blind: everything has to be either rosy or dark grey. They are usually prompt to raise their ratings and their estimates when fundamentals improve. They are late to downgrade their ratings as they do not want to jeopardise their relationships with corporations, infuriate their investment banking colleagues and volunteer for the next chopping block. Estimates fall but not nearly as fast as they were once raised. There is built-in institutional inertia to factoring decline in ratings and estimates. Meanwhile, old stock market darlings just drop off the conversation and gradually fade into oblivion.
The second reason is psychological. As scientific as it may sound, fundamental analysis is inherently subjective. Facts just aren’t data; they are weaved into “logical” arguments called investment thesis. For fundamental participants to admit a stock could be a short, they must first go through the intellectual divorce of accepting that it is no longer a Long.
Fundamental market participants grieve their way into short selling. They go through the Kubler Ross cycle of grief. Only in the final stage do they finally wake up and accept that the stocks they once loved could be short. Everything prior is discounted, or ratonalised.
DARP: the un-sexy flip side of GARP
Many market participants invest on the Long side following a Growth at Reasonable Price (GARP) methodology. They look for visible growth prospect with reasonable valuation support. They shy away from hyped stocks.
Frothy valuations is the premium market participants put on growth prospects. Once growth prospects disappoint, the premium gets arbitraged away. Valuations come down to reasonable level, on par or at a slight discount versus their peers. This gives the illusion of fair valuation or discount relative to peers.  There is no news flow that would draw attention, such as big earnings revision, or product recall. Yet, growth may continue to be sluggish. Growth stocks move to the value camp, and value stocks drift to value traps. Stocks imperceptibly under-perform their peers, the market. Welcome to the world of Decline at Reasonable Price (DARP).
This notion of DARP is difficult to comprehend for most fundamental investors. They practice Growth at Reasonable Price (GARP) on the Long side.  So, they believe they should do the opposite on the short side. They naturally tend to look for unreasonable valuations coupled with unsustainable growth prospect, or even imminent collapse. As we saw before, the last 5% to the top and from the bottom have claimed more participants than the 90% in between.
Investors struggle to find shorts because they look for the wrong clue. They focus on rich valuations when they should look for relatively sluggish growth. This puts a glass ceiling on share price appreciation, i-e the famous “valuations stay cheap for a reason” argument.
In a nutshell, there is no smoking gun on the short side: profitable shorts do not stand out. The best way to picture a profitable short is to think of it as dull long stocks. On the short side, boring is good. Boring under-performs.
Conclusion: Empty your cup
The short side is is a vastly unexplored continent: the Terra Incognita of short-selling. It has its rules and its dynamics, largely unexplained.
Market participants come to the short side full of the assumptions they carry over from the Long side. The theory that they bring along has a sobering encounter with reality. This brings frustration, disappointment, anger and eventually atonement.
Yet, success on the short side carries its own rewards. Those who master the skill can craft their own performance profile, levy higher fees, attract and retain investors.
The short side has more than one paradox. Whilst volatility is elevated, success comes from looking for stocks that other investors casually dismiss as boring.
Let us know what You think, your experience. Comments are always welcome. Please share with your friends and colleagues

10 myths about short selling

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Steven Spielberg’s movie Jaws has changed forever the way we perceive sharks. Did you know that deep in the comfort of your house lies  something 150 times deadlier than any great white shark ? The probability of dying falling out of bed is 1 in 2 million.  The probability of dying as a result of an exploratory shark bite is 1 in 300 million. Fortunately, we are not on the menu; sharks apparently don’t like junk food.
Like sharks, short sellers are fragile and misunderstood creatures. They are not the nefarious speculators. We are your pension’s best friend
[This is one of the chapters of the upcoming book: “the wisdom of short sellers”. We value your comments and feedback. So, please, help us helping You]

Myth 1: short sellers destroy your pensionbest-friends-forever-glitter-for-myspace

Would it be fair to say that people who hurt your pension should to be fired ?
According to www.Spiva.com, around three quarters of active managers trail their benchmark year after year. Your pension account is therefore better off with passive funds rather than expensive active managers. In bear markets, active managers might claim they outperform their benchmark, when the reality is they still lose money.
Your pension account does not need short sellers in bull markets. During bear or volatile markets, short sellers do make money. Counter-cyclicality is in the job description. So, all your pension account need is an allocation algorithm (see chapter on asset allocation by trading edge) to deploy between passive long funds and active short sellers.
Conclusion: Who is your friend ?
  1. Long Only active managers who have a sustained long term track record of hurting your pension
  2. Short sellers who will make money when the going gets rough.

Isn’t it fair to say that short sellers should be your pension’s new BFF ?

Myth 2: Short sellers destroy companies

The wisdom of short sellers is rarely welcome at executive boardrooms. As a result, they cannot bring healthy balance to the Dunning Dunning-KrugerKruger (*) dark side of the force. Senior managements at companies like Apple (round 1), Lehman Brothers, Kodak, Enron, GM,  Volkswagen are perfectly arrogant, incompetent and stubborn enough to run their venerable institutions into the ground themselves. Short sellers do not compound sub-optimal executive decisions, otherwise referred to as stupid mistakes. They see something going down  and just hop on for the ride.
 (*) Dunning Kruger effect is a cognitive bias in which people are so incompetent that they actually believe they are talented. This affliction is quite prevalent with senior management operates at such altitudes in the layer cake that they incorrectly believe it does not have to stink any more. This is reinforced by an obedient bozocracy,  bureaucrats whose sole “raison-d’etre” is to vigorously acquiesce.

Myth 3: Short sellers manipulate markets

Back in the days, a celebrity hedge fund titan used to publicly announce his investments in Japan. During the ensuing rally, retail flow remained strangely net seller, despite all the hype on investment blogs and chat rooms. Moreover, after-hours dark pool activity showed big blocks were exchanged. Someone was going through great length to discreetly unload a big position…
Had this manager done the exact same thing with a short instead of a long position, he might have attracted a different kind of attention. The public and the regulator do not take it kindly when someone publicly short sells across the nation pension funds large holdings. If You are a short seller, You will be audited. So, it is in your own self preservation best interest to strictly abide by the Law at all times.
If your business model revolves around putting on big short positions and then talk your book, then stop reading this, go buy some coffee mugs and lots of cheap coffee, because “los Federales” are on their way.

Myth 4: Short sellers want the demise of the economy

As we will see in this book, short Selling is a relative game. It comes down to selling the stocks that trail the index and buying the ones that outperform it. There is nothing nefarious about this type of arbitrage.
When market participants turn a bit more risk adverse, speculative stocks tend to come down harder and faster than the boring ones. Your average pension fund manager certainly had initial healthy professional skepticism as to the long term prospects of www.pet_cemetery_in_outer_space.com internet start-up or www.cash_crematorium_diagnotics.com biotech venture. Yet, he just felt pressured into buying, because everyone else did and he did not want to be left out trailing the index. This would cost him his job. Now, that things have hit a bit of a “soft patch”, he is left scrambling to liquidate this toxic nonsense. It is unfortunate that pension accounts end up littered with hollow buzz stocks, but again, short sellers are not responsible for other managers suboptimal investment decisions. They just short-sell underperformers.
 

Myth 5: Short sellers destroy value

Short sellers do not destroy any more value than shareholders create any. If You buy a house, a car, a pen today for 100 and resell it tomorrow for 105 without having done anything to improve it, You have not created any value. You have just made a profit of 5. This comes from a confusion between market capitalisation, value and valuation. The press likes to associate market capitalisation going up or down with value creation or destruction. Warren Buffet said: “price is what You pay, value is what You get”

Myth 6: short sellers are responsible for the collapse of share price

Short sellers need to borrow stocks in order to take short positions. Borrow availability is usually between 5 and 10% of the free float, or shares publicly traded. This represents between on and two weeks of trading volume. Short sellers do not have the fire power to durably affect share price.
Short sellers and big mutual funds have access to the same information. Share prices collapse as result of Long-Only heavy artillery selling, not small time short selling BB gun.

Myth 7: Short sellers accentuate market volatility

Some jurisdictions ban short selling. As a result, buyers can only purchase from a long seller. Sellers can only sell to Long buyers. This widens the bid/ask spread, which increases daily realised volatility. Market participants sell short for different reasons. It is often a way to hedge other transactions such as options, convertible bonds, preferred stocks, baskets etc. Inability to sell short reduces liquidity, increases volatility and ultimately penalizes all market participants. Banning short selling is often a sign of immaturity.
 

Myth 8: short selling increases risk

In theory, unsuccessful shorts can rally multiple times but only drop by 100%. Short-selling is risky, no doubt.
Yet, adding a short book to a long one reduces correlation to the index. It reduces portfolio volatility. The ability to sell short enables alpha generation not only in up but in sideways and down markets.
Think of it as boxing. If You stepped into the ring with Mike Tyson, and chose to punch only with your right hand, what was a tough fight to start with, will be a brief one too.

Myth 9: I don’t need to sell short during bull markets. I will just put on some shorts when the market turns bearish

Short selling is a muscle. It atrophies when not exercised. It is safer to learn the craft during bull markets when the long side can sponsor the tuition. Waiting for the bear market to show up is too little too late. It takes time, effort and money to master the skill, especially the mental side of short selling. Meanwhile, investors are notoriously impatient during bear markets. “the best time to repair the roof is when the sun is shining”, JFK

Myth 10: Short selling has infinite downside potential

If short sellers allow their positions to go up against them multiple times, then they deserve to be un-apologetically weeded out. Short-sellers is an extreme market sport. Joe Campbell got famous after breaking the three basic rules of short selling:
  1. always place a stop-loss: if You don’t have an exit plan, then You will not like what the market has in store for You
  2. control risk through position sizing: the most important question about fund management is: would You rather earn less than You could or lose a lot more than You should ?
  3. stay away from crowded shorts like penny stocks: risk is a binary event: either bankruptcy or recovery.

[Comments, feedback are uppermost welcome. This is a collaborative effort]

Stock trading: Is Short Interest Ratio (days to cover) no longer a useful indicator for short selling?

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My answer to Stock trading: Is Short Interest Ratio (days to cover) no longer a useful indicator for short selling?

Answer by Laurent Bernut:

This ratio gives the illusion of usefulness. There are two variables here: volume and utilization. Volume tends to dry up in down markets but picks up in climaxes. So, number can improve as everyone else sells !

I actually built something akin to days to cover back in 2005, before it was even popular as Short Interest ratio. I thought back then it was slicker than shorting fee, which was a lagging indicator. I then realised the paradox of a declining number in a selling frenzy.

Market cap bias

Another distortion came from the market cap bias. Small caps are apparently hard to short because of liquidity constraints. Yet, older listings sometimes have surprisingly high percentage of borrow available. This means if You can sit through the volatility (I can’t personally), You may have a chance.

On the end of the spectrum are large caps with complex capital structures. They are liquid but hard to short.

Example: big institutions have complex capital structures and can be heavily shorted by all sorts of participants such as fixed income arbs, L/S, P/E mezzanine holders etc. They can be heavily shorted while having 0.1 days to cover. So, You can’t source the borrow or find it usury and poor quality while having the illusion of liquidity.

Borrow utilisation: clean and simple

I then moved on to something simpler, robust and unambiguous: short utilisation.

Short utilisation = Shares borrowed / Shares available for borrow

This has one variable. It unequivocally says if it is already heavily shorted. As a general rule of thumb, i cover my positions when utilisation exceeds 55%.

This is standard risk management procedure for two reasons:

  1. Limited reward to risk: beyond 2/3, it is fair to assume that bad news is old news. So, outcome is binary: either collapse or increased risk for minimal reward
  2. Cost: Short selling is a costly sport. The more heavily shorted, the more expensive it quickly gets.
  3. Short squeeze frequency: there are not many buyers of heavily shorted stocks. So, any bit of buying pressure can snowball into a short squeeze. It may not trigger my stop loss initially, but enough amateurs flushed out and it could eventually

Chain reaction, bad borrow, cost, limited downside, so why bother ?

Complexity is a form of laziness:

As with all indicators, work the math backward so as to understand what it is supposed to measure. In the case of “days to cover”, it is an imperfect view on short liquidation. It encourages a behavior to take small positions so as to avoid liquidity traps. It does not deter from taking positions however. Short ratio “days to cover” is a imperfect mathematical answer to a valid question: “if i short this stock, do i run the risk of not being able to cover in case of a squeeze ?”

Gandhi said that ahimsa non-violence is not avoidance of violence, it is avoidance of conditions that could lead to violence.Ahimsa

Do not short stocks that are  illiquid or prone to frequent short squeezes, and You will worry less about being stranded.

Conclusion

So, You are better off staying away from heavily short stocks altogether, which is recaptured in borrow utilisation.

Stock trading: Is Short Interest Ratio (days to cover) no longer a useful indicator for short selling?

Why is humility an essential trait of profitable short-sellers ?

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January 2016 was a difficult month for investors. According to Barry Ritholtz:s, 93% of investors lost money. Feeling helpless and crushed while watching your investments melt away is a terrible feeling that takes a devastating toll on emotional capital. There can’t possibly be anything worse feeling, except perhaps a skill aspiring short sellers have to master, humility.

If You want to profit from a bear market and if You want to hold your short positions long term, then You probably should read this article.

Turning away from the gates of Valhalla

In January, my performance roared out of the gate. i was up at around +5.9% mid-month. i was timidly positioned for a cautious slow start with a gross around 150% and -0.12% risk per trade. Despite being ridiculously conservative and vastlyunder-participating, performance was there day after day. Returns were not only one-sided either. It was quality performance : Longs pulled their weight too: sugar, gold, Fixed income, Forex USD Bull. This is the stuff hedge funds are made off. i have long argued that the secret to AUM is to perform when no-one else does. This was it. And then, i saw it coming. i even wrote a post about it on the first day it happened, January 20th . A short-squeeze was under way. At this point, i could have closed all positions, walk away with +5.9% and be the one who closed right at the bottom. The gates of heaven were opening: Valhalla, shiny and chrome.

But then, i did the unthinkable. i went to work, methodically reducing bet sizes. i chose to take as little profit as necessary. i chose to forfeit all those profits and promises and then sat by the side of the road, waiting for the market to humble me all over again. And sure enough it did. It peeled off rock star returns, money for my family, fame, marketability, anything anyone would have aspired for. By the time Mrs Market was done with me, i had lost 90% of my gains: i went from +5.9% to +0.59% in less than a week. i was humbled alright, but i ended up profitable still. More importantly, I am better positioned now for round 2. Humility is a critical skill and below are the lessons from my journey

Two certainties in life: death and short squeezes

There are two certainties in life: death and short squeezes. There is no way to predict how long, how brutal short squeezes will turn. Why they happen is irrelevant: exhaustion of selling pressure, irrelevant but reassuring good news, government gesticulation, monetary intervention. Whatever the reasons, short squeezes are part of the short landscape and i have to deal with them.

Someone told me that short selling a stock at $1 can still yield a juicy 50% return if it drops to 50 c. True, at least in theory. The real question is would he still be there after price rallied from 52 c. to 70 c., or 30% in 4 days ? Very few people have the testicular fortitude to hold steady. i don’t, and this is why i have developed a methodology that enables to ride short squeezes.

The triple R methodology to weather a short squeeze

Short squeezes happen with 100% certainty. It is not about if, only about when. Rather than thinking of them as pestilence, i came to appreciate them and make good use of them. After all, they provide good entry points, plentiful borrow and flush amateurs (it is hard to feel sympathy for impatient people who jump in the water after vaporetti). Without further ado, here is the triple R methodology:

  1. Reduce: bet sizes as soon as You perceive a short squeeze
  2. Ride the squeeze. Do not short sell on the way up, but trim Longs that got clobbered in the downturn
  3. Reload: once the squeeze fades: lower stop losses and top-up existing positions

In practice, it looks like the chart below:

​Reduce

i am a trend follower. My objective is to ride positions as long as trends are valid. So, as soon as i see a squeeze coming, i reduce risk. i cannot control how vicious and how long they will last, but i can control how much damage they will inflict to the portfolio. So, the first step it to reduce bet sizes, so as to capture some profit and reduce subsequent potential damage.

Whether You trade German Bunds, US equities or colorful language with your significant other, You deal in one thing: risk. Risk is not a story. Risk is number. Since there is no way to predict how unpleasant a squeeze will be, it is prudent to bring risk to neutral as soon as You see it happening

Above is a picture of my portfolio in late January:

  1. Open Risk (pink bars) = Shares * (Cost – Stop Loss) / NAV
  2. CTR (Contribution, light green) = [Shares * (Price – Cost) + Realised P&L] / NAV (Scale out model, hence realised P&L)
  3. Weight (blue bars) = Market Value / NAV
  4. Weight at risk (orange bars) is weight (blue) where Open Risk (pink) is still negative

In simple terms, i try to bring the orange bars to neutral. At the onset of a squeeze, my objective is to have as many positions as possible with a neutral or positive risk carry. There are several ways to do it, but if You are new to the method, just halve your positions. Example: if You have -0.50% open risk and +0.25% profit, halving the position will reduce risk by a factor of 4: from -0.50% to -0.125%.

Important: make a note of the mental chatter while You are closing your positions. Which side wins: fear with “close it all, You don’t know what tomorrow is made off” or greed “just one lot, and leave everything on the table, that’s the way to get rich”. This mental chatter is an important window into your psychological market make-up. Journal your thoughts and emotions, You will find treasures

Ride

“Everybody’s got a plan until they get punched in the teeth”, ​Mike T​yson Mysteries

Now that all the hatches are closed, that i am safe and sound in the cockpit, time to find this bottle of stiff spirit and roll with the storm. The only permissible trades are Longs: close poor performers during squeezes and buy resilient stocks as they underperform.

The hard part is to accept to let go of your paper profits. You have to accept that short squeezes will come and go, that they will wreck your portfolio and that You will have to watch it happening and keep calm. This is part of the game. Roll with the punches.

Important: Journal your fears. There is a tremendous wealth of information here. This is an exceptional opportunity to learn about what makes You tick.

Reload

“it is not about how about hard You can punch, It is about how hard You can get punched and keep coming back”, Rocky Balboa

The whole purpose of the method is to go past the squeeze and reload. Alright, i got humbled, but i am still standing and now it is my turn to hit back. In the above chart, the positions with long green bars have gone through multiple stages of reduce/reload. Australia, Junk bonds, oil, natural gas and Jim O’Neil’s BRICs have delivered over time.

Once the squeeze is over and stocks start to roll over again, it is time to:

  1. Reset the stop losses lower: swing high + n * ATR
  2. ​Reload existing positions
  3. Reallocate resources to new promising shorts

Example: SPY was entered at 202. It represented -3.8% of the portfolio. Only 0.8% was necessary to cover so as to ensure break even on the remainder position. Previous stop loss was at 209.92. Current stop loss is at 201.23, below cost. This gives +0.15% of positive risk carry to be deployed to another tranche of SPY.

​Short-selling is not like Long buying: You cannot buy once and throw away the key. Shorts shrink, so You have to keep topping them up. Every time a stop loss is lowered, residual risk decreases. This goes far beyond eliminating risk. Positions continue to accumulate positive carry along the trend. This gives a distribution like the chart below where best performers have 5:1 reward to risk.

The -1 peak stands for positions being stopped out. Failure is the primary ingredient of success.

-2 and below positions are positions that woke up way below their stop losses. EWM was a good case in point: i closed a Short, open a Long and a week later the position lost 30% overnight. Volatility was high, so size was small anyhow. It was unpleasant but not hurtful.

As You can see, the methodology is simple: reduce risk, ride the storm and reload. Yet time and again, i have failed to execute and in the beginning at least so will You. Now, would You like to know why ?

Marshmallows, or why i used to fail to execute a simple methodology as the triple R

90% of trading is mental, the other half is just good maths. The triple R methodology relies on three principles

  1. Commitment: this methodology only works if i am committed to hold your positions long term. If i just want quick gratification, i will take profit too early and never allow them to fully mature. Similarly, i would never have the stamina to be slapped around so much
  2. Clear trading plan: commitment is directly proportional to the clarity of the trading plan. People don’t fail because they don’t have a plan. They stumble because they have complex ambiguous ones.
  3. Mental reframing: We are hardwired to do the exact opposite of the triple R​Loss aversion: Kahneman Tsversky have demonstrated that we are risk adverse with profits and risk seeking with losses (i am writing an awesome must-read & practical post about this + Jungian archetypes and neuro-chemistry BTW, so stay tuned)Process versus outcome: performance is the outcome of a good process. ​​delayed gratification: the single predictor of success in life is whether You will eat the marshmallow. Behind the adorable cruelty there is a profound principle Faith: it is simply the perseverance to trust and execute a plan. In the Jungian archetypes, those are the resilience of the orphan combined with the vision of the magician and the discipline of the ruler

Beyond the fascinating academic research on the brain, i came to find a simple conclusion. The reason why i failed was poor habits. As soon as i became conscious of my habits, i became able to fashion new ones. A simple habit is to reset stop loss. Another is to take profit at the onset of a rally. A third one is strict position sizing. All those habits have fashioned my investing style.

So, when the short squeeze was upon us, it was not hard to step aside and let it pass, however petulant it could be. It is a habit now.

Conclusion

“if You can meet triumph and disaster, And treat those impostors just the same”, Rudyard Kipling

The short side is the Antarctica of the markets. It is out there, not too far from civilization, but vastly unexplored at the same time. My stance on short selling is simple: if You think a stock is short, don’t fool people with writing a book about companies fooling people, don’t talk your book to Bloomberg reporters, don’t sue companies. Just locate some borrow, place the trade and let the market give its verdict. Those are no market wizards strategies, those are marketing wizard gimmicks.

Being a good short seller requires a lot of humility. A short squeeze is always around the corner. It takes a lot of strength to forego instant gratification for the sake of long term rewards. So, when the month ended at +0.59% instead of +5.9%, did i feel bad ? Of course, it hurt, but then: Mr Short Squeeze, is that all You got ? Now, my turn…