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