Selling Short – Considering Risk and Reward

I’ve noted from reading investment blogs and Yahoo Message board posts that there seems to be a great deal of interest in short selling.  Maybe it is the general mood about the economy.  Maybe some folks first tried short selling during the big slide in 2008 and found that they could do no wrong.  (It is said that every buyer is a genius in a Bull Market.  In a Bear Market, every short seller is a genius.)  Maybe there have always been a lot of people dabbling in short selling and the blogs and message boards have just created better venues for them to advertise their adventures.

What has disturbed me, however, is some of the types of short positions that people are taking.  While at first blush short selling seems no different from going long, there are some important differences that must be understood. 

First of all in buying long, time is on your side.  Because the general direction of stocks is up (because the economy is always growing), one can usually just wait out bad spells in the economy.  If your stocks are all falling, the best thing to do is to just stop looking at them for a while.  Usually you’ll be happier the next time you look (and not just because they’ve done a reverse 10 for 1 split).  This is doubly true if you use the stock picking techniques described by this blog and find stocks that have good long-term growth characteristics.  In short selling, time is against you.  If you are wrong about a stock, because the markets tend to go up, your loses will normally continue to grow the longer you wait to close the position.

The second difference is that when you buy a dud, the size of the position becomes smaller relative to the size of your overall portfolio.  If you’d bought Microsoft in the early 80′s and five other stocks that no longer exist, you’d probably have forgotten all about the other losers by now and be living on an island somewhere.  What if you’d thought Bill Gates was full of hype, however, and shorted Microsoft?  Even though the other five also went to zero, your Microsoft position would have grown to gargantuan size.  You would have needed to work five jobs just to keep funneling enough cash into your account to avoid a margin call.  There is no such thing as a limit to your losses when you sell short.

Given these traits, it is important to consider risk and reward when contemplating a short sale.  While that stock that has fallen into the penny range from the teens may be likely to disappear completely, with 10,000 shares you might only make $5000 when it does so.  If you are wrong and a venture firm decides to buy the company and offers $3.00 per share, you stand to lose $25,000.  If the stock recovers and goes into the teens, you could lose hundreds of thousands of dollars.  The potential reward is not worth the risk taken.

So, before taking a short position, consider the potential reward (how much can you make if the stock drops by 50%, and how likely is that to happen) and the risk (how likely is it for this stock to move upwards, and how much could it move if it does so).  Look for stocks that are already so overvalued that it is very unlikely that they could go much higher.  Find stocks with lots of cheerleaders and high PE ratios.  If everyone likes the stock, they have already bought in and it will be difficult for them to push the price higher.  It also helps if the market in general is nearing a peak, since when the whole market is falling every stock is a dog.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Hedging a Stock Portfolio the Best Way – Reduce Your Position

Through the last several posts we’ve reviewed covered some different ways to hedge positions in stocks and other investments.  This included:

1) Selling short companies in the same industry or other industries that one would expect to fall along with the industry in which the investor is long:  http://smallivy.wordpress.com/2010/06/07/hedging-a-stock-position-using-short-sales-protecting-a-portfolio-in-a-bear-market/

2) Buying put options on the shares: http://smallivy.wordpress.com/2010/06/18/how-to-hedge-a-stock-position-using-put-options/

and 3) Selling covered calls, which produces income and provides somewhat of a hedge since the income from the call writing offsets some of the losses when the stock price falls:  http://smallivy.wordpress.com/2010/06/13/covered-call-writing-how-to-make-most-any-stock-pay-a-dividend/

While each of these strategies will provide a hedge, each also has its downfalls.  Because stocks can continue to go up for some time even when the market is due or past due for a fall, one may need to cover short positions before the market does finally does capitulate.  Things can also happen to individual stocks such as buyouts that cause the shares of your short sale to rocket up, forcing you to cover the position. 

Put options expire, and you may end up buying put option after put option, only to see them expire worthless.  Then the day that you forget to but a new put is the day the market will fall 10%. 

Writing covered calls is a conservative strategy, but what do you do when the stock has fallen by 10%?  Do you buy an offsetting call to close out your original position, where the call was written at a much higher strike price,  and then write a new call at the lower price?  What if the stock then goes up?  Do you close out the position, taking a loss, and then write another call, hoping the stock goes down again?  Also, what if the stock goes up 10% after you write the first call?  Do you close out the position and take a loss on the call you wrote, risking that the stock would then fall?

Perhaps the best strategy for hedging, and the only one suitable for serious investors who are investing to make a great deal of money rather than gain some entertainment, is to simply sell off portions of a position once it becomes large enough to worry about losses.  If a position seems particularly pricey, in that it would take several years for earnings to justify the current price, it is best to close out the position.  If it looks like the entire market is about to fall, it is probably best to close out some of the positions that have done really well, or at least take some money off of the table, and start pooling up resources to buy after the fall. 

One must be careful, however, in that most of the returns of the stock market are due to a few day’s worth of gains.   If one is constantly diving into and out of the market, one may miss one of those days, which could mean the difference between making a 15-20% annualized return and 5% return.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Hedge a Stock Position Using Put Options

Put options are a type of insurance contract designed to prevent the loss of money when a stock falls in price rapidly.  A put option is a legal contract that gives the individual who buys the put option the ”option” — not the obligation —  to sell 100 shares of a stock for a fixed price (the strike price) on or before a certain date (the expiration date).  The person who creates the put option is called the put writer since he “writes” the legal contract.  (In actuality, no physical contract is written, the person wishing to write the put option simply calls his broker and indicates he wishes to write the put option; gives the stock name, expiration date, and strike price; and then the option is created.

The strike prices for put options are at specific intervals of the stock price.  At lower stock prices the strike prices are at smaller intervals and they spread out as the price of the stock increases.  The expiration dates are also specified at regular intervals, with options expiring on the third friday of the month (for example, a June option would expire on the third friday in June).

In exchange for agreeing to buy the stock at the fixed price, the option writer collects a premium from the option buyer, just as a car insurance dealer collects a premium to ensure an automobile.  The price of the premium depends on two factors, the difference between the current stock price and the strike price, called the extrinsic value, and the time remaining on the option, called the intrinsic value.  Note that the volatility of the underlying stock is also a factor, since stocks that move up and down rapidly are more likely to move below the strike price at some point before the option expires than are stocks that are fairly stable.  The intrinsic, or time value of the option tends to stay fairly stable until about 90 days before expiration, at which point the value decays rapidly.

While options are used commonly for speculation, the only suitable use of options for serious investors is in their pure use, that as an insurance contract to protect against losses.  For example, say an investor had 1000 shares of XYZ corporation and had a good profit, but already had a lot of capital gains for the year and wanted to avoid taking the gain for a few months until the new year started.  The investor might buy 10 January put options with a strike price a few dollars below the current price of XYZ.  In that way, if XYZ fell in price before the expiration date in January, the investor would limit his loss since he could sell his shares at the strike price.  He would also lose the premium paid if he exercised the option.

Once purchased, put options can be sold and the position closed by writing another put option of the same strike price and expiration date.  For example, if our investor bought 10 January 50 put options to cover his 1000 shares of XYZ from losses, and the price of the stock dropped to 40, his put options would now be worth $10 (the extrinsic value) plus the remaining intrinsic value.  The premium might now be $11 or $12 or more, depending on how long it was before the options expired. The investor may decide that he would rather keep his shares, now that the price has fallen and seems less rich, thereby avoiding a capital gain on the stock or the costs of closing the position and buying the shares anew.  Because the investor has the option to sell the shares, rather than the obligation, instead of exercising the puts and selling the shares he may decide to write 10 January 50 put options.  This would then close the position by creating an offsetting obligation, collecting $11 in premiums, say, and he would be able to pocket the difference in premiums.  If he originally paid $3 for the put options, he would pocket ($11-$3)*1000 shares = $7000.

Note that just as few people use their automobile insurance during any given policy period, few put options expire with the stock price lower than the strike price.  Because the probability that the stock will be below the strike price at the expiration date is priced into the premium paid for the option, most individuals who buy put options will lose a little bit of money compared with just selling the shares outright.  It is therefore not a good strategy to buy put options repeatedly.  Instead, they should only be purchased when the investor wants to stay invested for a short period longer, but is worried that the stock may suffer a sudden drop in price. 

They may also be used when, for some reason, the money will absolutely be needed within a few months to a year but the prospects for the shares are so great that one does not just want to sell the shares now.  For example, there are rumors of a takeover or a short squeeze is likely.  90% of the time, however, it is better to just sell the shares if the money will be needed and avoid paying the premiums to buy calls.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Hedging a Stock Position using Short Sales – Protecting a portfolio in a Bear market

 In a previous post, I defined what a hedge was and reviewed the different ways to hedge a stock position:

http://smallivy.wordpress.com/2010/06/01/how-to-hedge-stock-positions/

Today I’m going to start giving more details on the different ways to hedge, starting with short selling.  The reader is refered to the category, short selling, from the list on the right sidebar for posts related to the basics of short selling.

Let me first start out by saying that hedging using short selling can be risky.  It may seem like just the inverse of buying a common stock, so that the risk would be ablout the same.  This is not the case.  The primary reasons are as follows: 

1) The size of the position becomes larger if the stock you’ve shorted moves against you (up in price), and will continually suck more and more cash out of your portfolio so long as the position continues to go against you.

2) The market has an inherent upward bias, so short selling requires a degree of timing.  This means that it is not only necessary to be right about the direction of the stock’s price movement, but the timing of that movement within reason as well.  It does no good to be right that a company will go bankrupt if the stock doubles in price, forcing you to cover the position at a loss, before the price falls and the company goes bankrupt.  Short selling is only done for a few months to perhaps a year.  Short positions of multiple years are not a viable option because stocks tend to go up over time.  They also tend to go down much faster than they go up, so if there has been a good movement down, it is probably time to end the position.

3) Even if cash is kept in the account to cover the value of the short sale, one can still end up in margin (owing money to the broker) because the position becomes larger as the stock moves up in price.  Cash must continuously be fed into the account to avoid a margin call, where the brokerage firm closes the position for you, or sells some stocks of their choosing to regain the money they have loaned to you.  This would generally happen at the worst possible moment.

4) The company that has been shorted could be bought out by another company, causing the share price to jump suddenly and forcing you to cover at a high price since the stock doesn’t continue to trade long enough for you to be proven right.  I had this happen to positions in Snapple and Golden West Financial.  In both cases the companies that acquired them ended up wishing that they hadn’t, realizing that they paid far too much, but that was little solace for me.

Because of the risks involved, I rarely use short sales as a hedging technique.  In general if I feel that a stock is overpriced, I’ll sell some shares – this is much simpler and cheaper.  The times that I may sell stocks short is when I feel that the whole market is about to fall, taking my stocks along with it.  The last time this happened was in the middle of 2007, and I went short several stocks that spring.  While it took a few months for stocks to really start falling, I was actually able to make a net profit on my portfolio while most others were losing 40% or more.

At times like the 2007-2009 period, because the whole market is falling, the risk becomes less since almost anything you short will be going down.  This is because the market is very overpriced and ready for a correction, so that when it starts to decline it will take everything with it.   The trick is to select stocks that will fall faster than those you are holding long.  It is therefore necessary to find the industries and sectors that will be hurt the most and the fastest to make sure you have and adequate hedge for your portfolio.

As an example, in 2007, reading the Wall Street Journal, (I don’t know why everyone seemed so surprised – the WSJ was covering the subprime lending mess for months before the fall) I saw that consumers were about to run out of credit.  In the years before the average consumer 1) ran up their credit cards, 2) refinanced their home, swallowing the credit card debt, and then 3) ran up their credit cards again.  I held a portfolio that included many retailers which I knew would be hurt by the coming housing crunch. Without the ability to pay for their spending by extending the mortgage on their house and financing their Happy Meal over thirty years, consumers simply had no money to spend.  There was no way, therefore, that my retailers would be spared.

Looking at the different sectors, I decided that if the refinancing boom came to a close and several borrowers started to default on the interest-only ARMs that they were taking out, it would hurt the lenders.  While I knew that the lenders were packaging up the loans and selling them to Wall Street, I figured that the lenders would not be able to issue new loans, lose their fees, and therefore see their stock prices decline.  I therefore started to short some of the lenders, including, unfortunately, Golden West Financial.

I had thought of shorting the home builders.  Looking back on it that would have been far simpler and direct.  I was worried that, with the run they were having, their stocks might continue to run up for some time.  Looking back on it though they had made such a run that there was little risk that they would continue to climb. There was unlikely to be any earnings surprises on the positive side.

I also shorted the oil refiners, predicting (correctly) that high gasoline prices and declining consumer spending would reduce the amount of gasoline sold and hurt refiner’s profits.  This bet actually did better than I expected since many of the refiners I shorted didn’t produce oil.  This meant that they saw consumer demand drop and needed to drop the price at the pumps, reducing their profits, while they saw the price of oil continue to soar, which forced them to buy their raw material at higher and higher prices, greatly reducing the spread they enjoyed between their costs and the price at which they could sell their product.

In looking at the prices of the housing lenders and the oil refiners, I saw that they’d had a great run over the previous few years.  I decided that market conditions were such that everything was going to fall in price.  I decided that the economic factors would hurt refineries and lenders especially hard.  Finally, I felt that there was little chance for oil stocks and lenders to move much higher, given the run that they had already had and the low likelihood that higher than expected earnings would occur.  If these factors had not been in place, I would not have taken the risk of short selling.

I started by taking a few positions, and then selling a bit more if the companies increased a little in price until I had postions that I felt were large anough to make a substantial profit and offset losses, but were still managable should they increase in price further.  By the end I had about equal long and short positions in my portfolio.

In summary, short selling is an effective way to hedge risk, but it must be done very carefully.  It should also only be done when the whole market is about to fall, and the prices of the stocks you’re shorting are so high already that it is very unlikely that they could continue upwards much further.  Also, short selling is a short-term trade, so timing is important in addition to being right about the price direction.  Even then, surprises such as a buy-out can happen, so be sure to have plenty of cash in the account to cover positions that go against you.

 Finally, don’t make things too complicated.  Just short stocks that will likely be the first casualties of the market fall, not companies that might be hurt by the after-effects.  If you are right about the market turn and the first-tier of companies fall, there may still be time to short the second and third-tier companies.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Hedge Stock Positions

Today I’m starting a new topic category, which is hedging.  Hedging was covered to an extent in previous posts on short selling, but those posts seemed so popular that I thought I’d spend a little more time covering the techniques of hedging.  Today I’ll cover the basic ways to hedge and then provide more detail on the techniques in future posts.

In speaking about hedging we’ll assume that the investor is primarily long to start with, meaning that the investor will make money if the stocks he/she owns go up in price.  Most people are long most of the time and this makes sense because the market’s long-term tendency is always up.  Being short for a long period of time would be like entering a turbulent river and expecting to travel mostly upstream.  Hedging a short position can also be done just by doing the compliment of the trades I describe.  For example, buying a call option instead of a put option.

One often associates hedging with risk, largely because of the term, “hedge fund” applied to the high risk/high return funds purchased by wealthy individuals.  These funds get their names because they can take long or short positions, but often these funds are not hedging.  Instead they are using large amounts of leverage to make large gains from relatively small movements in the markets.  This causes a substantial risk of losing money.  True hedging actually reduces risk.

To hedge is to take up positions that are designed to offset long positions, such that the investor will be less susceptible to losses due to falls in the market.  If an investor is perfectly hedged, he/she will not lose money no matter what the market does.  Note that by taking up these positions, one also limits or eliminates the possibility for making gains while the hedges are in effect.  The following are ways to hedge a long position:

Selling shares of the same stock short-  This is also called “selling short-against-the-box” and forms a perfect hedge provided that equal numbers of the shares are sold short as are held.  No matter the movements in the stock, no money will be gained or lost.  (Note that if the stock price goes up an investor would need to add cash to the account or pay margin fees, since this would result in  negative cash balances in the account).  Selling short-against-the-box has little purpose other than delaying gains from one year into the next for taxes.

Selling shares of other complimentary companies short-  In this strategy, the investor sells short shares of a company that he/she expects to decline if shares of the company he/she owns fall in price.  For example, if he owns McDonald’s, he might sell shares of Wendy’s short, figuring that is the market turns against fast food companies shares of both companies will fall.

Buying put options- A put option is a legal contract by which someone agrees to buy shares of a stock for a predefined price before a certain date.  This can be though of as an insurance contract on the shares of the stock.  In exchange for this agreement the owner of the shares gives the seller (called the writer) of the put a certain amount of money, called the “premium”.  For example, a put option for selling 100 shares of XYZ stock at 50, good for three months, might cost $300 when the price of XYZ was at $51 per share.

Writing covered calls on the stock-  Here a contract is written that allows another individual to purchase your shares for a fixed price.  This limits the amount the investor can make on the shares (since if they go up above the agreed to sales price they will be purchased for the sales price) but reduces losses somewhat if the shares decline in price due to the premium collected.

Buying short ETFs- This involves buying short exchange traded funds (ETF).  These are financial instruments that are designed to go in the opposite direction of a particular market segment or index.  For example, an owner of several mining companies might buy a short basic materials ETF as a hedge against a fall in commodities prices or a slowdown in goods production.

Selling a portion of the position- The simplest way to guard against losses in a position is to simply sell some or all off the position.  This, of course, reduces the possibility of future gains.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.