Short Selling

Profit in Chaos.


The word short-selling is usually seen as bad by most outside of finance. You bet against companies and, hopefully, make money when they trade lower. It’s a weird concept at first but it’s one of the many fascinating things about markets that we have.

I like short selling. Whether it’s short-selling shares, buying puts or inverse ETFs. It’s not that I want to see companies fail but rather that It can be a lucrative business model, at least it used to be. I got my taste of it on a major level in 2011-2013 working for a family office where one of the themes I spotted was for-profit education. That was the era where University of Phoenix had celebrities graduating and the idea of online college was really starting to take off. At that point I really didn’t know too much about structuring shorts so I had to learn from other guys on my desk.

Now there are are two types of shorts I like:

  1. Event-driven shorts

  2. Technical shorts

I don’t have a preference to either but event-driven shorting is where you tend to have better P&Ls. Usually, with event-driven shorting you are going after situations where there are bad actors (think Enron or Valeant) and in that sense, you are doing, in my opinion, good for the overall market. Take for example most recently, Nikola Motors and Muddy Waters. They called out the bad actor, Trevor Milton, and at first, like they always do, they say it’s false. It’s usually followed by ‘we’ll seek legal action’ etc. to keep the facade going for a little while longer but in the end the truth always comes out. This was similar for the for-profit education companies back when I was on a 24 month short position with them.

The event-driven side usually has some catalyst that sparks it all and then once the masses wise up to it (which takes time) then the walls tend to come down. The hard part is, when you’re a smaller player, shorting companies can be hard because you need the word to get out on the findings you have to support said thesis so usually you are reliant on firms like Muddy Waters or others. However, you get situations like Evergrande, which we are seeing now, where you don’t necessarily need them.

This is what I would call a macro-driven short selling opportunity. What do I mean by that? You have a firm that has massive debt tied to it with bond holders from some of the worlds largest banks and mutual funds who own said debt. Now you can dig and find out where that all spreads out to but, usually, the idea of a debt default is enough to get the waters bloody and have the sharks come circling.

These are ideal situations.

Now, Evergrande has been called out for some of their operations/tactics for over 10 years and while China is not something I specialize in, I pay attention here and there because of how big of a force they are in the global market plumbing. Usually, there is phase one, as mentioned: general fear, which causes all equities (usually) globally to sell a bit. Then, there is phase two: liquidity. Like I said, I am not an expert in China so I usually default (and did) to friends who spent time working there and talk with others to get their insights on things like this.

In fact, there is a really good Twitter thread on a lot of it here that is worth a read.

When we were shorting for profit colleges, the idea was easier - you just shorted the equities (University of Phoenix, Corinthian etc). But, with Evergrande, it’s a bit trickier because shorting the actually company, this late in the game is hard.

So, how do you do it?

There are a few ways that I’ll share here.

  1. Find sectors that are reliant on China (US equities)

  2. Inverse ETFs

  3. Chinese equities that will be affected by “bad China” press

  4. Short US futures

(For the record, the bad China press is not highlighted enough, if you follow China even slightly it is, in my opinion, warranted).

The miners (BHP, FCX, FMG) are already seeing pressure and will continue to do so. I am short one of those names because I know it well and understand it’s correlation to China. So when picking an equity to express an idea, like macro-driven short, I want to short what I know. What also comes into factoring the short-side on the equities side are things like:

  1. Borrow rates

  2. Liquidity

  3. Underlying options volume on the equity (ies)

Now why does that matter? When you get situations like we are seeing, especially in any event-driven short, where the fundamentals back it you have to ‘go for the jugular’ as Soros once famously stated. I would venture to say an amateur would and could use an inverse etf, say like, $YANG, and potentially do well. However, I am not after amateur gains so I want to dig deeper and structure the entire trade thesis as best as I possibly can to generate as much alpha as possible.

Usually, you can combo some short equities with short futures as well. I like this because of the ‘Phase 1’ concept I mentioned. You usually get a nice risk-off phase to start and usually they happen during European trading hours where you can get out of index shorts and secure gains. All the while, you can (if plan goes perfection) ride your equity shorts on the equities that will surely see larger sell-offs as more is uncovered from a default situation like we might be seeing.

Now, and I will keep this short, there is technical shorting. Technical shorting will come into play in situations like this in general equities as well as futures. This is a byproduct of risk-off across global markets. What I then try to do is look at ‘the worst’ looking charts I can find and put on trades that are OTM puts. Nothing too big, almost a tail-risk (but not really) idea where, if, say a stock really comes off the highs due to a global sell-off, that cocktail of OTM puts on select equities, pay me off handsomely. If not, I don’t lose too much and my core shorts (along with futures) can do well.

How much can a macro-driven short opportunity spill into other sectors, say, such as US housing? I am not smart enough to answer that but it’s something that I ask myself and from there, start to watch data on US housing a bit more than I normally would to see if, at some point, there is opportunity there as well.

Hopefully, you see a bit into shorting here and how certain situations can be lucrative when done correctly. I mean, it’s not an ideal situation, especially for the people that work at Evergrande or others affected by this, but in some fucked up way, these things have to work as they do to re-create other opportunities for other market participants. Look at Nikola for example. Them being outed likely opened up market share for companies that actually have a proper product and well run business to become more notice by investors around the world.

Thanks for reading, I will do a second part to this soon.

PS: You can watch a 2-hour video lesson on retail trading v. professional trading here.


As always, remember to incorporate yourself with 5 stars.

Daniel

This article is presented for informational purposes only, is an opinion, and is not intended to recommend any investment, and is not an offer to sell or the solicitation of an offer to purchase an interest in any current or future investments. Any such solicitation of an offer to purchase an interest will be made by a definitive private placement memorandum or other offering document.