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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Find a method to evaluate stocks-- and build a record of impressive returns Short Selling for the Long Term describes the methods used by Joseph Parnes, President of Technomart, to obtain consistent returns in the stock market. Most investors fail to exceed the returns represented by the Standard and Poor's Stock Index, but Parnes often does using his investment philosophy. This book outlines his method of stock assessment, providing an understandable formula. If the formula tells a reader to buy a stock, then, as explained, there is a significant chance that stock will go up. If the formula tells a reader to short a stock, then the book shows how there is a significant chance that the stock will go down. Parnes advocates the use of short selling as a long-term strategy in combination with long positions, so advisors and individual investors alike can profit in both rising and falling markets. While most investing books focus on how to make money over the long term in a rising markets, Parnes's focus on short selling as a way of capturing volatility sets this book apart from the crowd. He offers insights into the difference between option trading and shorting which make his system useful in both type of markets. * Profit in a bear market * Borrow the stock you want to bet against * Sell borrowed shares * Learn the secrets of long-term short selling strategy * Buy shares back and close by delivering at the new, lower price Short Selling for the Long Term is essential reading for investment advisors, fund managers, and individual investors.
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Table of Contents
Cover
Preface
CHAPTER 1: Investment Philosophy
CHAPTER 2: The Bank of England Lecture
The Presentation
CHAPTER 3: Portfolio Management—General Principles
My Asset Allocation of a Portfolio
CHAPTER 4: Explanation of the Use of the 50-Day Moving Average and 200-Day Moving Average
Staying Above the 50-Day Moving Average
The Golden Cross
Staying Between the Parallel Tracks
The Double Dip
The Death Cross
The Support Line
The Resistance Line
CHAPTER 5: The Theory Behind the “Parnes Parameters”: Using Pattern Recognition, Retrospective Analysis, and Bayesian Analytics
CHAPTER 6: Variables to Consider for the Parnes Parameters
Fundamentals: Getting Down to Basics
Assessments Using Technicals
External Factors
CHAPTER 7: Shorting for the Long Term
Case Studies for Long Positions
Case Study Method
CHAPTER 8: A Case Study for a Stock I Shorted for the Long Term—Chipotle
Case Presentation (This is not a recommendation to buy, sell, short, or cover the short)
Case Study for Shorting a Stock for the Long Term
Interpretation of the Parnes Parameters
CHAPTER 9: Case Studies for Integrating Shorts for the Long Term with Longs
Principles of Shorting for the Long Term
Multiple Shorts
Hypothetical Example of Shorting for the Long Term
CHAPTER 10:
Modern Trader
Charts
ISRG (An Intuitive Surgical Short, Modern Trader, #529, February 2017, p. 12)
BHP Billiton (The BHP Bottom Isn't Near, Modern Trader, June 2016, #521, p. 13).
BHP Billiton (Iron Ore Bust, Modern Trader, December 2017, #538, p. 15)
Six Examples Where the Evaluation of Both Fundamentals and Technicals Warranted Shorts
Polaris Industries (Recalling Polaris Stock, Modern Trader, #527, December 2016, p. 14)
SINA (Shorting SINA: China's Twitter, Modern Trader, #525, October 2016, p. 13)
Stamps.com lnc. (Stamps Stock: Return to Sender, Modern Trader, #540, February 2018 p. 15)
Goldman Sachs (Goldman Will Rebound, Modern Trader, #520, May 2016, p. 10)
Goldman Sachs (GS: Anticipating the Swamp Bump, Modern Trader, #534, August 2017, p. 14)
Fiat (Fiat Chrysler in Low Drive, Modern Trader, #524, September 2016, p. 13)
Chipotle (Short Sell: Tainted Grub, Modern Trader, #518, March 2016, p. 12)
Chipotle (Chipotle: New Health Outbreak, New Short, Modern Trader, #536, October 2017, pp. 14–15)
American Express (AXP: Don't Leave Home Short, Modern Trader, #532, May 2017, p. 12)
Amazon (Yes: Amazon Is Different, Modern Trader, #536, October 2017, p. 16)
Long Fangs, Short Fangs (Long Fangs, Modern Trader, #522, July 2016, p. 12)
Glossary
Index
End User License Agreement
List of Tables
Chapter 5
Table 5.1 Probability of an Event Based on
T
-Test Calculation
Chapter 9
Table 9.1 Investing for the Long Term versus Trading for the Short Term
Table 9.2 Various Approaches to Buying a Long Position
List of Illustrations
Chapter 1
Figure 1.1 The short and long positions in composite portfolios for 2016.
Figure 1.2 Feature in
Barron's
.
Chapter 2
Figure 2.1 Letter from the Financial Markets Law Committee (FMLC).
Chapter 4
Figure 4.1 This stock was in death cross territory, and then switched to gol...
Figure 4.2 Standard & Poor 50 dma and 200 dma.
Figure 4.3 NASDAQ 50 dma and 200 dma.
Figure 4.4 Chart of 50-day and 200-day moving averages for a buy scenario....
Figure 4.5 Chart of 50- and 200-day moving averages for a short sale scenari...
Figure 4.6 Example of a support price line.
Figure 4.7 Example of a resistance line.
Chapter 5
Figure 5.1 Gaussian distribution, the bell-shaped curve.
Figure 5.2 Probability curve.
Figure 5.3 Preakness at Pimlico.
Chapter 7
Figure 7.1 Apple 50 dma and 200 dma chart (this is not a recommendation to b...
Figure 7.2 Venn diagram of factors influencing stock performance.
Figure 7.3 Amazon Five-Year 50 dma and 200 dma.
Chapter 8
Figure 8.1 Chipotle Mexican Grill Revenue (TTM) chart.
Figure 8.2 Golden cross reverses to death cross.
Chapter 9
Figure 9.1 Example of cup with handle.
Figure 9.2 20-Year gold price in USD/oz.
Figure 9.3 Head-and-shoulders reversal.
Figure 9.4 Chart courtesy of StockCharts.com.
Figure 9.5 Chart courtesy of StockCharts.com.
Figure 9.6 Chart courtesy of StockCharts.com.
Chapter 10
Figure 10.1 Technicals scream sell.
Figure 10.2
Figure 10.3 Failed rebound.
Figure 10.4 IBM death cross.
Figure 10.5 A rough road.
Figure 10.6 Crossing over.
Figure 10.7 CLB short energy.
Figure 10.8 No relief in sight.
Figure 10.9 Marked down.
Figure 10.10 Time to sell.
Figure 10.11 Pick your gap.
Figure 10.12 Long way back.
Figure 10.13 GS technicals looking up.
Figure 10.14 Out of gas.
Figure 10.15 Taking a dive.
Figure 10.16 Big level.
Figure 10.17 Death cross.
Figure 10.18 American Express.
Guide
Cover
Table of Contents
Begin Reading
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Short Selling for the Long Term
HOW A COMBINATION OF SHORT AND LONG POSITIONS LEADS TO INVESTING SUCCESS
Joseph Parnes
Copyright © 2020 John Wiley and Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
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Library of Congress Cataloging-in-Publication Data
Names: Parnes, Joseph, author.
Title: Short selling for the long term : how a combination of short and long positions leads to investing success / Joseph Parnes.
Description: First Edition. | Hoboken : Wiley, 2020. | Includes index.
Identifiers: LCCN 2019051847 (print) | LCCN 2019051848 (ebook) | ISBN 9781119527763 (hardback) | ISBN 9781119527787 (adobe pdf) | ISBN 9781119527824 (epub)
Subjects: LCSH: Short selling (Securities) | Stocks—Prices.
Classification: LCC HG6041 .P296 2020 (print) | LCC HG6041 (ebook) | DDC 332.64—dc23
LC record available at https://lccn.loc.gov/2019051847
LC ebook record available at https://lccn.loc.gov/2019051848
Cover design: Wiley
This book is the culmination of decades of hard work and could not have been completed without the support of my wife and son, close friends, and the team at Wiley.
Preface
There is a reason some of you may have not heard of me before. I am neither a billionaire nor a talking head; rather, I consider myself to be a contrarian. I have been personally successful regarding the stock market in terms of developing a short and long strategy. I have taken a long time—almost 30 years—to write this book, as I have taken some issue with those who are so dramatically successful and purport to offer a path to becoming a similarly situated billionaire. There is a reason there are so few of them around, and I believe that this book instead illustrates my personal strategy, not premised on the claim that one will become handsomely rich for all time, rather on my ability to become financially independent. I believe this goal is truly attainable and reflective of the seemingly vanishing American dream.
So who am I? I emigrated to the United States from Tehran, Iran after graduating from high school prior to the Iranian revolution of 1979. The United States seemed to hold the most promise for me, so I obtained a student visa and enrolled in college to study engineering. I financed my way through college by working as an X-ray technician at a local hospital over nights and weekends. These were very difficult times for me. My parents in Iran had both passed away, I had no relatives in the United States, and I had arrived with no money. I was able to complete my studies in engineering in three and a half years, due to my advanced placement in mathematics (obtained by taking a qualifying examination). After years of studying engineering and economics, I landed my first job in New York City, at Western Electric, which was the manufacturing division of AT&T.
Starting in the 1970s, amidst the Watergate and oil crisis, contrary to most investors I started investing in the stock market. I soon recognized that short positions, when used in conjunction with long positions as a hedge, enhanced my returns. I began making money, started publishing a market letter called Shortex, and founded Technomart R.G.A. Inc. (also known as Technomart Investment Advisors) to manage other peoples' money. I began to get media attention, and eventually, I appeared on CNN-FN, Bloomberg, CNBC, and radio and TV stations all over the globe. I am grateful to have been featured in Forbes, Barron's, and Investor's Business Daily, to name a few of the publications. In 2011 I was invited by the Bank of England and the Financial Market Committee to appear before the Financial Market Law Committee (FMLC) of the United Kingdom to serve as a keynote speaker on short selling before an audience of members of the Appellate Committee of the House of Lords, which is most analogous to the US Supreme Court. I am currently the editor and publisher of the Shortex Market Letter and president of Technomart Investment Advisors.
This book illustrates the art of short selling, which is quite difficult to master for most because of the scarcity of float and/or liquidity. On the one hand, shorting can generate impressive gains. On the other hand, it exposes its traders and investors, at least in theory, to a loss, and the expenses for carrying charges. In the past decade I feel that both high-frequency traders (HFTs) and institutional traders have had the ability to influence the market through programmed trades and subquotes done in nanoseconds, putting the individual short seller at an inherent disadvantage.
I have developed a relatively reliable selection method, which I call short selling for the long term, that I describe further in this book. The short positions in portfolios of $1 million and up are based on the initial premise of the 130/30 investment model. This means I invest 100% of the portfolio into long positions, and then select stocks to short, representing approximately 30% of the total value of the portfolio. I then take the proceeds from the shorts and reinvest that money into long positions. This gives me 130% of the portfolio in a long position and 30% of the portfolio in a short position. Depending on individual objectives of investors, and market variables, a single portfolio may have a 120/20 to 200/100 ratio of long to short holdings. Using the typical 130/30 model, I select long positions that equals 130% of the nominal capital invested and select short positions that equals up to 30% of the nominal capital, giving a net market exposure of 100%. The book explains this concept in detail and it is my sincere belief and hope that you will find it of tremendous value.
CHAPTER 1Investment Philosophy
This book discusses my methods for evaluating the market, which differ significantly from those of many money managers. Succinctly stated, I invest—I do not trade. This book is an explanation of my method of investment.
Individual investors have individual needs. This book describes a methodology that allows an investor to determine if this investment philosophy is compatible with their own needs. Some people are risk averse while others want income. Only you will know what works best for you. This book may provide you with the information that you need to help you with your decisions. Please see Figure 1.1.
Figure 1.1 The short and long positions in composite portfolios for 2016.
The pie chart in Figure 1.1 represents the short (18%) and long (82%) positions in composite portfolios for 2016. The long-to-short ratio is 4.8. This ratio changes year to year, depending on market conditions. In a bear market, there are more short positions than 18%, and in a bull market, there are more than 82% long positions.
The role of any investment advisor is to supply private and institutional clients with practical investment advice. This advice may encompass experience across a broad array of industries, with a special focus on growth companies and short-selling strategies. Many of my investment recommendations have appeared in Barron's, Forbes, Investor's Business Daily, and Modern Trader. I have been featured in and contributed to a broad array of media, including Bloomberg TV, CNBC, and First Business News. I have been recognized as one of the top wealth managers in 2004–2012 by Bloomberg Wealth Manager and featured in Barron's (Figure 1.2) and Forbes. These media outlets all seem to be interested in my investment approach. I was also invited by the Bank of England to be the keynote speaker at the Financial Markets Law Committee (FMLC) meeting in London. This committee was created by the Bank of England and was chaired by Lord Hoffmann, a former member of the Appellate Committee of the House of Lords, which is now called the Supreme Court, and is most analogous to the US Supreme Court.1
I employ a proprietary bottom-up approach to investing that focuses on company research, fundamentals, technical analysis, and cash flow to evaluate superior opportunities for long and short investment opportunities. Strategies may include sector balancing, growth, cash flow, bonds, income, short selling, risk aversion, and other investment strategies. These terms will be explained later, in appropriate sections of the book. I focus on in-house company research to evaluate the fundamentals, technical analysis, and cash flow on the various issues selected. In-house company research often carries none of the biases of research from institutional investors, which often have significant holdings in the companies that they recommend for purchase, which is out of date by the time it is published.
I discourage investors from becoming clients if they depend on the money they want us to manage for living expenses. If you have certain minimum living expenses that require a return on investment, these must be secured first. If you need funds for living expenses, this creates a situation where the investment philosophy of the client is counter to my own investment philosophy. This day-to-day need for funds clouds the judgment of an investor. If you are going to invest for the future, and invest to grow your assets, do not use money you need to live. Simply stated, do not invest money if you cannot afford to lose it. Only put surplus capital into an investment fund. Ideally, you should invest, and check in routinely to see how you have done, but do not worry about short-term changes. The current market conditions that are impacted by global traders creates a new environment and produces a more volatile market than in the past. The natural market fluctuations, retractions, hiccups, sell-offs, and so on are to be expected. Do not let the volatility impact your investment judgment. You will want to sell off when there is a short-term profit, rather than hold for the long term. When an issue drops 15–20%, it takes a truly sophisticated investor to see the long-term picture by seeing the drop as an opportunity.
Trading is not the hallmark of my strategy. It is my belief, developed through years of experience, that maximum returns will be lost in a short-term trading strategy. Very often, once a position is traded with the thought of repurchasing the position later, some other factors have intervened and the repurchase opportunity is lost. Many times, once a position is sold out, not only will there be a tax burden to the investor but discipline is needed to reacquire the position. The advantages of having held the position at a lower price are often lost with a repurchase strategy. The inconsistency of traders in repeating their previous gains would subject the investors to a new element of the risk. Therefore, my trading strategy is best described as “not trading.” A company with solid fundamentals, good management, a strong cash position, little or no debt, a reasonable price-to-earnings ratio compared to its peer group, and a strong market position compared to its peer group has all the elements of a solid investment. This type of company will be able to ride out various market bumps, corrections, and sell-offs, and should be held for the long term. The shortsighted approach of “take my profit and run” probably reduces the overall return on investment when calculated over a six- or eight-quarter period.
Being a wealth manager, my intent is to maximize performance and its value in the time frame of one to three years, or even five years, by a double- to triple-digit increase in asset value invested. I select long positions based on a strategy of following the technical analysis over time, and fundamentals. My clients' accounts are customized commensurate with the objectives of the investors. I personally and actively evaluate 40 to 60 issues. Then, based on the requirements of the individual client, I usually narrow down investments in a single portfolio of 18 to 24 positions, dividing the assets in large accounts into $30,000–$60,000 or higher tranches. Basically, the more positions in the account, the less the volatility. This degree of diversity helps weather the normal market fluctuations while capitalizing on and maximizing the profit potential of individual issues.
The aggregate portfolio of a client varies subject to risk tolerance and objectives of the investors and the size of the portfolio. I review the movements, corrections, and retractions of each issue. Near-term objectives, intermediate objectives, and stop losses are set and reassessed on each issue to avoid being “stopped out.” For individual issues, I look at 10-day, 50-day, and 200-day moving averages, which are viewed as a tool to evaluate the momentum of the various issues, knowing full well that the deviations, plunges, and down-gaps may involve institutional, hedge fund, or mutual fund investors taking positions or eliminating positions (these terms and their significance will be explained in the appropriate sections of this book). When the momentum of a stock overextends its respective movements above the set barriers or resistance lines, I know it is time to reevaluate that stock. On long positions, I look for relative strength as well as flow movements: short positions of institutional investors play a strong part in that evaluation.
Shorts are difficult to master, primarily because of the scarcity of float/liquidity, that is, the number of shares available. Ideally, I maintain 10% to 15% of the initial stock value as a stop loss in short trades, depending on the volatility of the issue. In volatile long positions, I evaluate the stop loss, depending on the retraction, to see if there is a change in the fundamentals of the company, or if the retraction is in response to some external event, such as commentaries made by short sellers, to drive the price of the stock down. Eventually, due to the strength of the fundamentals of the company, the short sales will dry up and the price will rise due to covering of the shorts. By being aware of certain market investors or traders, such as high-frequency traders (HFTs), computerized high-frequency trading (HFC), institutional traders, and algorithm traders, who capitalize on volatility to enhance their performance, I look for them to cover their short position, which typically drives a stock to even higher prices. Contrary to the herd mentality, I take note when the level of bullishness on the subject issue becomes overextended. I focus on technical elements on an issue when the following elements become transparent: overheating, primary/secondary support level, breakdown, topping (on individual issues in the general market/sectors), and trading charts that show ridging/head and shoulder, plunging gaps, reverse cup with handles, volume, deterioration of accumulation/distribution mode, length of the distribution, downward penetration on the 50-day and 200-day moving averages, and formation of the “death cross” pattern. All these terms and their applications and implications will be described in the pages that follow. Other data of importance in short selling are short interest in the New York Stock Exchange/NASDAQ composites, put/call ratio, major indices trends, and volatility index.
While a home-run investment in the stock market is usually spectacular, I am not looking for the “big kill.” Those astounding investments with 500% or 1,000% returns in three months do happen, but they happen far less frequently than people taking losses. I always remind people that for many years, Babe Ruth held the Major League Baseball record for the most home runs in a single season, hitting 60 homers in 1927, while playing for the New York Yankees. But in his effort to send the ball out of the park, he also had a huge number of strikeouts, with 89 in the same year. In 1961, Roger Maris hit 61 home runs with 67 strikeouts. Compare that to Reggie Jackson, who hit 47 home runs in 1969 with 142 strikeouts, or Will Stargell, who in 1971 hit 48 home runs but had an astounding 154 strikeouts. You often hear about the great number of home runs of these players, but rarely do people mention the strikeouts, or, even more importantly, the ratio of strikeouts to home runs. When reexamined in those terms, Ruth had a strikeout-to-home-run ratio of 1.48, while Maris had a 1.09 ratio, Jackson had a 3.02 ratio, and Stargell had a 3.20 ratio. This means that Stargell was more than three times as likely to strike out as he was to hit a home run while Maris had a little less than even shot at it. Now we are getting down to useful numbers and into the realm of predictive analytics. If you invest with a money manager, is he going to have the Roger Maris result or the Will Stargell result?
I want to make money for my clients slowly and methodically, by pursuing logical investment goals. I am perfectly content with a single or an occasional double. In the long term, I will accumulate more runs with these “single-base” advancements than by trying to be a home-run hitter.
The short positions in the portfolios of $1 million and up are based on the premise of the 130/30 investment model. This means I invest 100% of the portfolio into long positions and then select stocks to short, representing approximately 30% of the total value of the portfolio. I then take the proceeds from the shorts and reinvest that money into long positions. This gives me 130% of the portfolio in a long position, and 30% of the portfolio in a short position. Depending on individual objectives of the investors, and market variables, a single portfolio may have a 120/20 to 200/100 ratio of long to short holdings. Using the typical 130/30 model, I select long positions that equal 130% of the nominal capital invested and select short positions that equal up to 30% of the nominal capital, giving a net market exposure of 100%.
I have shared these investment philosophies, especially on the use of shorts, in the course of dealing with various media contacts I have had. I have found that magazines are results oriented, so I was pleased when they kept returning to me for material. They were particularly interested in my use of shorts to enhance long positions, and my philosophy of using shorts in lieu of puts, calls, and margin accounts. Using the 130/30 model technique, no more than 30% of a portfolio is in shorts, and then the proceeds from shorts are diverted/applied to other selected issues for their long-term growth rate. Apparent long-term appreciation in the value of these growth stocks makes up for the cost/fees/interest charges being levied by the lenders for the short position selected.
Caution—Limitations and Difficulties: On the advice of counsel, any securities mentioned in this book, with the exception of those mentioned in previously published articles, should not be considered a recommendation to purchase or short this security. These securities mentioned are used for illustration purposes only. The reader must not construe a mention of any stock as a recommendation to purchase or short a stock, or as a recommendation to trade options on any security. This book is designed to present concepts, not recommendations. Please consult your FINRA-registered financial advisor if any questions arise regarding the content of this book. Furthermore, the author does not claim that any device or system can be used to make decisions on which securities to buy or sell, or the timing of such decisions, irrespective of what limitations or difficulties are discussed. Any graph, chart, formula, or other device mentioned in this book is not to be used in making any determination as to when to buy or sell any security, or which security to buy or sell.
Figure 1.2 Feature in Barron's.
Reproduced with permission of Barron's.
Note
1
Joseph Parnes has not given or received any consideration for any such media recommendations. Travel and accommodations were provided by the FMLC.
CHAPTER 2The Bank of England Lecture
On January 14, 2011, I unexpectedly received a letter from Joanna Perkins, the director of the Financial Markets Law Committee (FMLC) in the United Kingdom. This letter can be seen in Figure 2.1. I believe I had come to the attention of the FMLC as the result of various comments I had made in the press about the use of shorts as part of an investment program. The Bank of England had created the Financial Markets Law Committee and had asked Lord Hoffmann to chair it. Lord Hoffmann was a former member of the Appellate Committee of the House of Lords, which had functioned as the final court of appeals. The committee was concerned with identifying areas of legal uncertainty that affected financial markets and wanted to properly inform members of the judiciary about market practices. Based on my expertise, I was invited to be the keynote speaker on the subject of short selling at the annual judicial seminar, which is considered the apex of the NLMC's yearly conference program. Other speakers were William Hautekiet from The Bank of New York Mellon, and Andrew Bagley from Goldman Sachs International. This private seminar was open only to members of the senior judiciary, such as Supreme Court judges, other judges with an interest in financial markets practices, and a few select financial experts. The committee had become concerned because new rules on short selling were being introduced into the European Union.
Figure 2.1 Letter from the Financial Markets Law Committee (FMLC).
Since I was addressing legal rather than financial experts, I made an effort to simplify the financial terminology, provide a background of the history of short selling, and then trace its evolution into the current status. Therefore, financial analysts may find this chapter too pedestrian while others without a financial background may find this chapter helpful. However, what is presented next is a verbatim duplication of what I told the Bank of England during my presentation.
The Presentation
NOTE: The following is a transcript of my presentation before the Bank of England. My rationale for certain aspects of my presentation is shown in parentheses.
There is a long history of concerns about short selling in the UK. After the Tulip Crash in Holland of 1600s and the Cook Island collapse in the early eighteenth century, England banned short selling outright. The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, precipitating a major banking crisis which included the collapse of almost every private bank in Scotland. The bank had been speculating by shorting East India Company stock on a massive scale. Short sellers were blamed for the Wall Street Crash of 1929. Political fallout from the 1929 crash led Congress to enact a US law banning short sellers from shorting shares on a downtick. This was known as the “uptick rule,” and this was in effect until July 3, 2007 when it was removed by the SEC (SEC Release No. 34-55970), which, in part, led to the 2008 market collapse. More importantly for UK citizens, George Soros became notorious for “breaking the Bank of England” on Black Wednesday of 1992, when he sold short more than $10 billion worth of pounds sterling. [This event triggered the start of great concern from the British banking community and judiciary about short selling. However, many did not fully understand the entire process, so I had to review what a short sale was.]
In a short sale, the investor thinks the value of a stock will go down, so he wants to sell it, even though he doesn't own it. This is the first of many risk factors that should raise a red flag. If you do not own something, how can you sell it? [So I had to explain this process to the audience.] A brokerage house “lends” the investor a stock, which allows him to sell stock short. The investor “borrows” the stock at a price in order to receive money for this sale. The investor pays a “stock borrowing fee.” The short contract remains open as long as the investor wants, for years if he wishes, with two possible options. The short sale can remain open until “covered” or called by owner of the stock. The investor hopes to “cover his short” by purchasing the stock at a lower price. The difference between the “short price” and “purchase price” is profit (or loss, if the price rises above the sale price). It is in this latter situation that the investor can lose money, unless he really wishes to maintain the short in the stock. In this case, the investor may have to post more collateral or cash to cover the paper loss, at the request of the lender, who is usually the brokerage house.
Let us review an example. XYZ Company is selling at $50 a share. The investor thinks XYZ is going to decline, so he borrows stock from the brokerage house, and shorts the stock, that is, sells the brokerage house stock at $50 a share. Since this stock is really the property of the brokerage house, the investor has to pay interest on the value of the stock, he has to pay the dividend of the stock, since he now “owns” the stock on a temporary basis, and he has to pay commission for the short sale transaction. Any time after a short sale (a day or a year later) an unfavorable report for XYZ comes out, and the stock drops to $40 a share. The investor buys XYZ at $40 a share, “covers his short,” and makes $10 a share, less his interest costs, any dividends which occurred during the time of the short, and another commission for covering the short.
There is a difference between shorting a stock and selling a stock. In a shorting situation, an investor “borrows” stock from the brokerage house to cover a short. The brokerage house charges a loan fee. Generally, the investor has to repurchase the stock to pay back the brokerage house (hopefully at a lower price). In a sales situation, an investor owns shares in a stock. The investor sells the shares of the stock. The investor delivers the stock certificate to the brokerage house. The brokerage house pays the investor within three days (the legal settlement time in the United States).
However, there can be problems with a short sale. If the stock the investor borrowed and sold goes up in price, the investor has to cover the difference with real money, or repurchase the stock at a loss, to repay the brokerage house. If the investor “shorts” XYZ at $50 a share but the stock goes to $60 a share, the investor has to produce $10 a share to cover the potential loss (a “margin call”) or buy the stock to cover the short. A margin call is the demand for money to cover potential losses, so that the brokerage house can be reassured that the investor will have the funds to cover any losses.
The entire short transaction process is pretty straightforward. This differs from a little known but highly prevalent (and illegal) practice of “naked short selling.” In this naked short sale transaction, the investor does a “naked short” of a stock. The brokerage house never delivers any security to collateralize the loan, and the broker knows that this is in violation of Financial Industry Regulatory Authority (FINRA) rules. However, the penalties are not enforced. Hypothetically, the investor can sell more than the issued shares of a company. Even though there is a FINRA Reg. T requirement to “locate” shares of stock in the company, the brokerage houses often ignore this, resulting in a failure to deliver.
Let us examine this in more detail, to try to understand the nuances of a naked short sale. In order to execute a short sale, a brokerage house had to lend a stock to an investor who was executing a short sale, that is, identify that the brokerage house had the stock it was going to lend in its inventory of stock holdings. However, in 1993, the Securities and Exchange Commission (SEC) changed their wording from “an investor may borrow stock from the brokerage house to cover the short sale” to “the brokerage house has to locate stock to cover the short sale.”
This change of regulations led to a marked increase in brokerage houses failing to deliver. A failure to deliver occurs when a naked short seller shorts a stock. The investor must post collateral to cover this short. But if the brokerage house doesn't deliver stock to cover the short, then there is a failure to deliver. There are regulatory penalties for failure to deliver, but they are not enforced. This failure to deliver situation can lead to many abuses, since a brokerage house can sell shorts without having stocks in their inventory to cover these shorts. Then, if a market correction occurs, the brokerage house is not in a position to cover all the outstanding shorts.
There are some practical implications to the naked short sell situation. As an example, say XYZ Company is selling at $50 a share. The investor thinks XYZ is going to decline. Naked shorts are executed on the stock by an investor, that is, stock is sold at $50 a share, but the brokerage house never locates stock to cover the short sale. Hence this is a naked short. A month later, or a year later, an unfavorable report for XYZ comes out, and the stock drops to $40 a share. The investor buys XYZ at $40 a share, covers his short, and makes $10 a share, less commissions, dividends, and interest payments. There is no problem in this situation, other than the fact that the transaction is actually illegal, due to the absence of collateral to cover the short.
Let us compare and contrast a short sale and a naked short sale. For a short sale, an investor borrows stock from the brokerage house to sell short. The brokerage house charges a stock loan fee and a commission on the transaction, and the investor is liable to pay the dividend due from the stock. When the investor decides to repurchase the stock to cover the short sale (hopefully at a lower price), he also pays a commission on the transaction, and the transaction is completed. This differs from a naked short sale. In this situation, the brokerage house allows an investor to short a stock before the stock is located, which creates the naked short. This failure to deliver may remain open for weeks or months. More importantly, there is no limit on the quantity of stock that can be shorted in this naked fashion, since there is no need to have actual stock in the brokerage house account.
This begs the question, How do the brokerage houses get away with this? Historically, stock certificates were actually counterfeited and used to support short sales. After the 1929 market crash, the Securities Acts of 1933 and 1934 were created in the United States. These acts created the Securities and Exchange Commission (SEC) and National Association of Securities Dealers (NASD, now FINRA). A letter ruling by the SEC in 1993 dropped the word “borrow” from the short seller's lexicon/rules, and substituted the word “locate” for the collateral stock. This same letter ruling created exemptions from even this rule for three kinds of traders: market makers, arbitrageurs, and hedged (fund) accounts. Once freed from the enforcement of Reg T, and using “ex clearing” (unreported trading hidden from regulators), brokerage houses began naked short selling. It is estimated that over the next 10- to 15-year period, 80% of NASD (now FINRA) member firms' profits came from naked shorting. The member firms primarily focused on small public companies on the OTC Bulletin Board and the Pink Sheets, which are in development stage. In 2002, one syndicate operator, Amir “Anthony” Elgindy, was arrested in connection with his activities surrounding terrorism, bribes of FBI agents, and money-laundering issues. His syndicate consisted of 650 members, including many large hedge funds.
The most troubling aspect of naked short selling is from the imputed “contra account” effect. Every time a share is shorted naked, a counterfeit long is created, but never registered by, known to, or accounted for by the targeted company. Some interesting twists in Financial Accounting Standards Board (FASB) and generally accepted accounting principles (GAAP) also entered into the naked short sellers' tactical equation. If naked short sellers bankrupt or cause the deregistration of a targeted company, they can avoid a revenue recognition event under GAAP, because the short needn't be covered. Therefore, since there was no revenue recognition event, according to GAAP, there was no taxable event. Because of this, naked short sellers often pursue their targets with unbridled aggression, always hoping for either (1) an involuntary deregistration of the company or (2) its actual bankruptcy. If either (1) or (2) occurred, according to the SEC rules, the shorts never had to be covered. The naked short seller could essentially launder money without tax consequence. It was tax-free income. These are backroom games, hidden from the public. Brokerage houses can avoid a traceable clearing and settlement of securities by using direct “broker to broker” clearings of securities, called “ex-clearing” (dark pools). Shorts and counterfeit longs can sit in “ex-clearing” and remain unreported. This tricks an investor into thinking he has bought (long) real shares in a company, but these are counterfeit shares.
C. Austin (Bud) Burrell, former executive vice-president of Shearson-American Express Lehman Brothers, is now one of the leading experts for prosecutors of naked-short selling crimes. According to Burrell, in a presentation at the Harvard Club in New York, the biggest perpetrators of the “crime” of naked short selling are the brokerage houses themselves, trading between each other using “ex clearing.” Burrell reports that naked short selling is a money-laundering scheme for organized crime and terrorist groups, and market manipulation. He recommends outlawing naked short selling.
There have been feeble attempts at this control. FINRA 4320 mandates 13-day buy-ins for open delivery failures. FINRA 2010-043 requires any short sale exempt trade to be reported. Market makers now must formally acknowledge that they are not locating stocks before a short sell, thereby creating a naked short sell. The third rule requires that offers and bids be approximately the same size, thereby preventing the control of stock movement using small trades to offset large ones.
While naked short selling is per se an illegal, criminal activity (although rarely prosecuted), short selling is a legitimate investment tool. Short selling allows an investor to make money even in a falling market. This is a valuable tool, because stock prices do not always go up. Stocks fluctuate in price, sometimes with reason and sometimes without reason. Shorts can be used to protect a long position or to hedge against a temporary drop in price. Conventional shorts are a tool for adding liquidity in the market, due to purchasing of the stocks, when the shorts are covered.
Since there are natural fluctuations in the price of a stock, the shorts are used to take advantage of this fluctuation. The proceeds of the short sale are used to increase the long side of the positions by the investors. This investment strategy covers all aspects of market fluctuations, where investment can be construed as 130/30. This means that the net market exposure remains 100% (130% long and 30% short).
When money managers use shorts as part of an investment philosophy, they focus on in-house company research, fundamentals, technical analysis, and cash flow to evaluate superior opportunities for long and short investments. Strategies may include sector balancing, growth, cash flow, bonds, income, short selling, dividend capture, risk aversion, and other investment techniques. However, astute money managers do not use short selling alone, but only as a tool to augment all investment activity.
I strongly believe that in-house company research is the most important aspect of successful investing. Research purchased from large brokerage houses often suffers from a persistent time lag. By the time an investor receives research, it is “old news,” and the market has already adjusted to the information. Often, the “research” is not considered objective; it advances the self-interest of the brokerage house.
[After my presentation concluded, I was deluged with questions about my approach. I tried to record these questions, and I have shared the answers I gave to the questions later in this book. I hope this book will prove to be a useful guide to the use of shorts for the long term as part of an investment philosophy.]
CHAPTER 3Portfolio Management—General Principles
I am responsible for supplying private and institutional clients with practical investment advice. I have experience across a broad array of industries with a special focus on growth companies and short-selling strategies.
