- Shorting can also be like buying insurance. Have you insured your car and house? Of course you have, but have you insured your portfolio?
- I’ll discuss a few ways to hedge yourself but also how to make money on the downside.
In my last few articles I’ve discussed the macro view on going short, the micro view on what to look for, and why you shouldn’t even think about going short. But if you’re still interested in going short, this article will go more into detail on the process of going short and will also discuss a few shorting/hedging opportunities to see what the returns could be, and most importantly, what the risks are.
There are two ways to go short, one is to sell a borrowed stock short with the hopes of buying it back at a lower price. The other is to buy put options.
The first might cost a bit less as the only cost is the interest rate you have to pay to borrow the stock plus commission, but it’s also much riskier because the loss is unlimited while the reward is limited and can be only 100%. Some will say that you can use stop losses or exit the position at a pre-set level if it works against you, but those are also risky plays as when stocks move fast, execution issues arise.
As I’m a person who loves to have limited risks and unlimited returns, I will focus more on what it looks like to go short through buying options. However, let me start by showing you a chart of a put option against the Italian bank Intesa San Paolo that Ray Dalio and his Bridgewater Fund has already been short on for a few months now.
In the last year, the EUR 2.5 put option went from EUR 0.89 a year ago to the current EUR 0.09 as the stock price is currently above EUR 3.
So the put lost 90% of its price as the stock appreciated and even since Dalio went short in November 2017, it has lost more than 64% of its value. The point in shorting is to manage your risk properly. Those who bought the put for EUR 0.9 in March 2017 did so when the stock price was around EUR 2 which is a high risk low reward thing to do even if the trend for the stock was negative.
Now, even if from March 2017 the stock would have fallen to EUR 1, the put option would be worth only EUR 1.5 so investors in that case would have been risking EUR 1 to gain EUR 0.5 which isn’t the best risk reward. On the other hand, if you buy the same put now at EUR 0.09 and the stock goes down to EUR 1, you might make 15 times your money as the put would again be worth EUR 1.5.
Intesa might go to 1 in the future, but no one knows whether it will be so in the next 9 months until the option expires. However, if you estimate the fair value of the stock is 1, you can take such a bet 15 times and still break even. That would be about 7 years. 7 years of losing money might be expensive, but it’s a strategy some take.
What’s important to mention here is that buying the put option now might be a good way to hedge yourself for a market crash. If stocks don’t crash, you lose a little bit of money. If they do crash, you’ll be happy you bought insurance.
Let’s look at other insurance opportunities available at the moment and start with the S&P 500. If you want to protect your portfolio from a market downturn up to December 2018, you have to pay 5.3%. To be protected until December 2019, you have to pay 8.5%. And to be protected on the downside up until 2020, you need to pay 10.3%.
So if you buy the December 2020 put, you are allowed to sell the SPY at $275 at whatever point in time up to then. All in all, insuring a portfolio doesn’t even cost that much.
If you are long FAANG stocks, you might want to protect yourself by buying puts on the Nasdaq index. At current prices, you can insure yourself against losses for less than 10% of the index value. If you think the Nasdaq will go up by more than 10% in the next year and a half, you might take advantage of that at no risk.
Going short or hedging yourself means doing something against our investing nature, that is to lose money without the possibility that it will be regained at some point in the future. If you buy a stock and the market crashes, there is always the hope that stocks recover.
However, would you drive your brand new BMW without insurance? No, so why do so many have their whole portfolios with more than their BMW invested in extremely risky stocks without insurance? If you are one of those people, I hope I have given you some food for thought.