A few weeks ago, I received a question from a reader:
"Would it be possible for you to do a post outlining what you’ve read and/or what your thoughts on shorting are? I know its sort of frowned upon in the value community so I thought it would be interesting to get your perspective and what you’ve read of others on the matter. Perhaps you could also discuss how you would evaluate the tradeoff between going long put options and shorting a given security outright?"18 or so months ago I wrote a post entitled: "Distressed Debt Investing's Book Recommendations: Equity Shorts" in which I recommended and gave summary reviews on five books dedicated to the practice of shorting. And when I was just a wee little (with one of my first posts), I wrote about how I approached shorts from a fundamental research standpoint. While I wasn't short DRI at the time of the post, it turned out to be a pretty decent short for short time being down 10% versus the market up 20% a few months later. To be frank, a lot of my thinking around shorting has evolved since that post. With that said, I do stand by this passage:
"You make money in the market by having different expectations about the future than the general consensus. If you think 2010 and beyond free cash flow will be substantially higher than the analyst community, you would be more apt to buy the stock."
"Of course, diversification is for us only the starting point for risk reduction. Solid fundamental research, emphasis on catalysts, value discipline, preferences for tangible assets, hedged short selling, market put options and other strategies combine to create an overall portfolio safety net for our portfolio that we believe is second to none" (my emphasis added).
- Shorting a stock while buying a way out of the money call on the name. While I give up some performance, my downside is capped (and even if my position is not 100% delta hedged correctly, potential loss is significantly reduced)
- Bearish vertical call spreads. I use this strategy more when the borrow is tight (enormous rebate) or impossible to find at one of my brokerages. In this scenario, I will often sell at the money calls, while buying calls further out of the money. I am taking a directional bet that both positions will expire out of the money. In this scenario, your loss is capped at the difference between the strike price of the two contracts used * number of contracts * 100.
- Buy puts. This is highly dependent on things like implied volatility of the various puts, as well as the tenor, liquidity, and strike prices. It is also highly dependent on being able to put to a catalyst to get the position moving to offet the premium which might be quite high given the volatility or lack of borrow in the name.