Thoughts on Short Selling and its Alternatives

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  • on March 11th, 2010

James Altucher, a managing partner of Formula Capital, has an interesting post on the nature of short-selling.

  • Never short based on price action. A stock that is going straight up can continue at least until you are bankrupt before falling to the ground.
  • Never short based on valuation. A stock might be expensive at 100 times earnings and it will be even more expensive at 200 times earnings.
  • Unless you are hedging, your short positions should be 1/3 the size of your long positions.
  • Believe it or not, short stocks that have high short interest. In general, short squeezes are a myth and stocks that have high short interest are usually shorted for a reason.

It might not makes sense to go long a stock that is up substantially in a short period of time, but not being a buyer doesn’t mean that you should be a short seller.

When selling short, paying attention to risk management is essential. Initiating smaller than usual positions for short ideas helps, but it is not sufficient to prevent a disaster if a stock gaps up substantially above your stop loss. There are alternatives to simple equity short selling. Alternatives that allow for more precise risk control:

1) buying puts – you know exactly how much you could lose if your thesis turns wrong. The maximum loss is the whole premium, which means that if you risk 0.5% of your capital on short ideas, 0.5% is the amount that you would lose in the worse case scenario. In general, implied volatility tends to rise as the price of the underlying asset declines; therefore if your trading thesis turns right, your option position is likely to benefit from rise in IV. There is one major exception to the rule of high negative correlation between the price of the underlying stock and the IV of its derivative contracts – it is called volatility crash, which occurs after the expiration of a major event such as earnings’ day or FDA approval day. IV is highly elevated before such major events due to the higher uncertainty about the potential impact of those events on the stock price. Once the news from such an event is known, the IV quickly retraces back to its  long-term mean disregarding the price action in the underlying stock. With two words, under the above explained conditions, IV  of options could drop despite a drop in price in the stock.

For example, instead of shorting SPY at 115.45 where it is currently trading, you could buy SPY $115 April PUTS at $2.35. The maximum loss that you can incur is the paid premium if you decide not to offset your position before it potentially expires worthless on the third Friday of April. If your trading capital is 100k and your maximum risk for short ideas is 0.5%, you would be able to afford buying only two contracts. (100k*.5% = 500 and 500/2.35 = 2.12).

The current delta is (-0.4916); gamma is 0.0683; IV = 16.19%; vega = 0.1439; tetha = -0.0307. Let see what is likely to happen with this position if SPY drops to 110 in the next 15 days and the IV of the option rises 3% points. Due to the drop in SPY’s price, delta and gamma will contribute to the option’s premium with approximately 5*0.4916+4*0.0683 = $2.73; the 3% increase in IV will boost the premium by 3*0.1439 = $04317; For 15 days, theta is expected to erode the premium by 15*(-.0307) = -$0.4605. The total impact on the option premium would be +$2.72 or 115% increase from the current base.

You could also sell OTM SPY March calls in order to take advantage of time depreciation, but with this approach it is much harder to manage risk. In a post I made last weekend, I mentioned that back then SPY $117 March calls were traded for $0.47 and SPY was offered for 114.30. 4 days later SPY is up to 115.45 and the SPY $117 March Calls are traded for .34 – a decline of 0.13. This is the power of time depreciation 10 days before option expiration.

2) buying put spreads- if you are concerned about risk and time premium, you might go with this approach. It will limit the potential reward, but decrease the negative impact of volatility and time depreciation. Another alternative is selling call spreads if you have an intention to take advantage of time depreciation and potential drop in IV. Currently the SPY 115/113 April Put spread is traded for about $0.75; SPY 115/117 April Call spread for about $0.97.

Certainly applying the above suggested tactics requires that the underlying stock is optionable and its contracts are liquid enough, so slippage is not an issue.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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