If you’re go­ing to be a short seller, here’s what you need to know

The Daily Observer - - BUSINESS - MARTIN PELLETIER Martin Pelletier, CFA , is a port­fo­lio man­ager and OCIO at Trivest Wealth Coun­sel Ltd.

There has been a lot of press lately on out­spo­ken short sell­ers who sup­pos­edly wreak havoc in the mar­kets and on com­pa­nies such as Valeant Phar­ma­ceu­ti­cals In­ter­na­tional and, more re­cently, Home Cap­i­tal Group Inc.

Short sell­ers them­selves typ­i­cally fit within one of two groups — those who re­main be­hind the scenes and are se­cre­tive about their po­si­tions and those who are quite vo­cal about why they are short a com­pany, in the hopes of driv­ing the price lower by in­flu­enc­ing others to sell the stock.

For those not fa­mil­iar with the process, short sell­ing in­volves an in­vestor bor­row­ing some­one else’s stock while putting up a per­cent­age of the po­si­tion as mar­gin and pay­ing a pre-set amount of in­ter­est, in­clud­ing cov­er­ing all div­i­dends. The in­vestor then pro­ceeds to sell the stock in the mar­ket with the goal of buy­ing it back at a lower price and re­turn­ing it to the lender.

Since the stock is bor­rowed the re­turns are es­sen­tially lever­aged, re­sult­ing in strong gains made when the stock sells off. How­ever, the pay­off pro­file is asym­met­ri­cal: The profit is lim­ited from the time it is shorted down to $0, while the risk is un­lim­ited mean­ing the share price has no cap on how high it can go. For ex­am­ple, let’s say you short 1,000 shares of a stock at $10. The max­i­mum profit on the trade is if the share price goes to $0 and you make $10,000. If the share price ral­lies higher to let’s say $20, you are down $10,000 on the trade and will ei­ther have to put up mar­gin to cover the new price or close out the po­si­tion at a large loss. Since there are no lim­its as to how high it can go the max­i­mum loss is un­lim­ited, mak­ing it po­ten­tially a very dan­ger­ous trade for those who haven’t done their home­work.

There is also a say­ing that mar­kets of­ten re­main ir­ra­tional longer than an in­vestor can stay sol­vent, mean­ing an in­vestor can be right with their trade the­sis but wrong with the tim­ing. Sim­ply take a look at the mon­strous rally in Home Cap­i­tal’s share price be­fore its re­cent col­lapse — those who were short the stock too early and ei­ther couldn’t stom­ach it or didn’t have the cap­i­tal to cover the mar­gin calls would have been hit with some large losses.

That said, there are a cou­ple of ways to pro­tect or limit the down­side risks when short­ing, but they are not with­out a cost. One method is to buy a put op­tion on a stock in­stead of short­ing it as the value of the put will in­crease as the share price falls. The ben­e­fit is that the down­side is lim­ited to the cost of the put but it also has an ex­piry date so an in­vestor could make no money on the trade if the share price does not fall be­low the put’s strike price prior to ex­piry.

One could also de-risk an ex­ist­ing short po­si­tion by pur­chas­ing an out-of-the-money call op­tion which will limit the down­side risk to the level of the call’s strike price. In the afore­men­tioned ex­am­ple, an in­vestor could by a call op­tion with a $15 strike thereby putting a floor on the trade with a max­i­mum loss of $5,000 (plus the cost of the call) against a max­i­mum gain of $10,000 (less the cost of the call).

While many in the in­dus­try dis­like short sell­ers as they profit on the losses of others, we do think they play a role in im­prov­ing mar­ket ef­fi­cien­cies by de­valu­ing or even even­tu­ally re­mov­ing those poorly run com­pa­nies from the pub­lic mar­kets.

Short sell­ers can also pro­vide great op­por­tu­ni­ties when they’re wrong, which can lead to a “short squeeze” in which they must cover or buy-back their short po­si­tions, thereby send­ing the stock re­bound­ing much higher.

Ei­ther way, it helps to un­der­stand the process and that those who are short of­ten have a very good rea­son for do­ing so given the amount of risk they are tak­ing on. It is there­fore up to you as an in­vestor to de­ter­mine if they are right or wrong.

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