Respect The Power Of Short Selling

A successful self trader – Rule # 23

We are all familiar with short selling; Just that we are too scared to do it. Selling without delivery has some inherent advantages. World over the shorts are looked down upon but normally more money is made on the short side of the trade than on the Long side. In short selling you play with gravity and levitation is never permanent. Learn to use this technique of short selling intelligently…

Short selling has its inherent merits

No discussion on trading rules is ever complete without an elaborate discussion on short selling. As the name suggests, it is selling without delivery. It takes many forms. You can sell short and cover intraday. You can sell short and borrow shares to give delivery. You can sell futures of current month or next month expiry and cover it when prices go down. Of course, if you are conservative then buy puts and if you are aggressive sell call options.

The first aspect of short selling is that it provides the trader a legitimate method to take a downside view on the stock or the overall market. Buy and hold is a great concept but in a market which is politically, economically and financially volatile, short selling provides that much needed buffer to your portfolio.

Secondly, short side indicators are always more visible and reliable. When a balloon attains too much height or too much inflation, the odds of coming down are always higher. Same applies to markets and stocks. Overvaluation, too much volatility, investor euphoria, geopolitical risks, overbought zone are all clear giveaways of a stock that is about to correct. Grab it!

THE 3 GOLDEN RULES OF SHORT SELLING

PROTECT YOUR CAPITAL WITH A 10% BUFFER

Any short sale has an overnight risk. Your rule book defines the maximum capital you are willing to lose in trading. If a 10% rise in the stock on opening can trigger that, don’t take overnight risk on that short position.

LEVERAGED SHORT SALE CAN BE TOXIC AND DESTRUCTIVE

When you sell futures decide the size of your position by the loss you can afford not by the margin you can afford. In short selling, it is always safer to err on the side of caution. Better still, stick to buying limited-loss put options.

KEEP A STRICT STOP LOSS DISCIPLINE

Stopping out is a very important decision when you short sell any stock or the index. Since you do not have delivery, stop losses should be triggered in volatile markets. Avoid liquidity risk in markets with stop profits and avoid the risk of getting into auctions.

In an uncertain market, you discount the obvious and bet on the unexpected” – George Soros

5 – FACTOR FRAMEWORK FOR YOUR SHORT SALE

1. Look at the global and domestic macros. Geopolitical risks, sell-offs in world markets, liquidity squeeze globally, spurt in inflation in India, rising interest rates, systemic risks are the typical macro risks that suggest you short the index or the stock. A combination of 2-3 of the above rarely goes wrong.

2. Any short sale should not be initiated without market level-factors. Is the delivery ratio falling rapidly? Are market P/E way above long-term averages and is the VIX (volatility index) spurting? Are we seeing sudden build up in short open interest? All these give critical clues for going short.

3. There are stock specific triggers which are critical when going short on a stock. Quarter on quarter slowdown in profits, weak guidance, audit objections, concerns on corporate governance, downturn in industry cycle, loss of pricing power are all very strong short side triggers.

4. In a short sell decision, the trend is always your friend. Even if all the first 3 factors hold good and the momentum in favour of the stock is positive, avoid short selling. At best, start off with limited loss put options and then once the trend is clear, look to sell futures. Remember Keynes, “Markets can remain irrational much longer than investors can remain solvent”.

5. Last, but not the least, monitoring your position is 80% of the job. Once a short position has been initiated regularly assess the global and domestic macros, changes in market data, institutional triggers, time value erosion of options, Mark-to-market losses etc. Tight monitoring of your short position is much more important than the great short selling idea.

CRACKING THE SHORT SELLING FORMULA

Believe me, short selling requires patience and perseverance and an ability to fight scepticism. Paulson who made the big short on sub-prime in 2007 had to hold on to shorts for close to 2 years. When Jim Chanos started

shorting Enron, nobody accepted a short on a blue-chip company. Even when David Einhorn came out with his famous short trade on Lehmann, the entire investment community was against him. The rest they say is history, but the moral of the story is that it requires much more patience, conviction and ability to fight scepticism as compared to a long position.

Short selling can be a great idea when the tide turns in a stock. Look at 2008. Every real estate stock corrected between 85% and 95% over the next 2 years. Technology in 2000 also corrected close to 90% from its peaks. Even blue chip capital goods stocks and PSU banks in India corrected 70-80% since the peak of 2010. The beauty of the short side is that once the trend is apparent, then sell on rises almost becomes a sure shot trade. Of course, you cannot forget the checks and balances.

TAKEAWAYS FROM THE “SHORT SALE” ARGUMENT

I always share a word of caution for short sellers. If you short sell stocks with the intent of buying back intraday, you need to worry about the auction risk. The losses can be crippling. The key risk in short selling is that any market the world over is dominated by buyers. Hence a short seller is always in a minority.

But in a volatile market it plays 3 important roles. It helps you participate in a market downside. Secondly, it enables you to hedge the risk of your long term holdings. And finally in enables you to avoid the basic risk of being short of cash in market bottoms.

As Jim Chanos said, “A lot of good performance you see by corporates and funds is either pure chance or good fortune. If you understand that, you will look at short selling very differently.” Apt words that, from a legend of Wall Street.

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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