MorningWord 5/9/14: All Sorts of Shorts

by Dan May 9, 2014 9:30 am • Commentary

As regular readers of Risk Reversal know we like to find opportunities to short bad, or what we deem to be misunderstood stories in any sort of market.  But how we use the term “short” is very different from the way most in the investment world think of it.  We like to say short biased, or short exposure, because to be frank, there are very few on the planet who really have the stones to dig in on the short side of the market the same way in which they fall in love with their longs.  From my experience as a trader on the buy-side, prop trader at a large bank and as a proprietary trader using my own cash there are very few market participants who have the wherewithal to really dig in in the short side for an extended period of time, and for obvious reasons – the risks are asymmetric vs. that of being long.

So let me break it down for you, at least the big fundamental directional… I’ll save quants for another post.

Traders at Investment Banks/Large Financial Institutions

– Those who have the mandate to take risk from the long or short side at investment banks have little care in the world between the risks of being long vs short.  It’s shareholders’ money if they lose, and the main risk is merely that of being fired for poor performance, which they also have from the long side.  And you would be surprised how easy it is to get another job at another top tier bank after blowing up if you have the right pedigree and are able to blame the origination of the losses from a “custy”.

Then there are the proprietary traders/ hedge fund portfolio managers.

– The prop guys trade what’s in front of them, long or short, they don’t outsize the market, they stay nimble in liquid names and do their best to avoid overnight gap risk.

-The hedge fund pm usually has a mandate to run a net exposure, meaning they have to have a certain percentage of their capital dedicated to short positions to offset some of the risk on the long side.  There was a time when this was mostly done with single stocks, but with the proliferation of etfs over the last 10 years fundamental stock picking on the short side has become a lost art.

But the ones who grab the most attention are the very ones who actually have the stones to dig in. The whales like Ackman of Pershing Square who in some ways has staked his reputation in his belief that Herbalife (HLF) is a pyramid scheme and has allocated a reported $1 billion of capital at risk to the bet that regulators will shut it down.  There is also Jim Chanos of of Kynikos Associates who called and made a bundle on the collapse of Enron in 2001.  There are plenty of guys from Steve Cohen of famed SAC Capital and many of his former employees that are currently in prison or are states witnesses who used to be very good at it, but they are a dying breed for a whole host of reasons, some of them more obvious than others 🙂

And then there are options guys like us who trade our own money and have no mandate or access to special info or unlimited resources for research.  Which is why we short the way we do… with defined risk.  We take out the asymmetric risk out of being short.  So when I am on CNBC and talking about my bias on a stock or a market, that is one thing, but how I express that view is a another thing.

To sum it up, there is a fairly small pool of capital relative to the entire pie that is dedicated to shorting stocks.  Why? Because over time stocks go up, so shorting stocks is more of a trading skill than an investment process.  As our CNBC friend Jim Cramer likes to say “there is always a bull market somewhere.” While we can’t disagree, we like to turn that notion on its head a bit and look for the next story that is about to crack.  So when the illustrious Mellisa Lee turns to me and says ” So Dan you are short NFLX… for the sake of transparency I do my best to identify how I have short exposure, with defined risk.