For hedge fund managers, too, short selling is more difficult than mere buying. A stock price, for instance, has a theoretical bottom line, and buying would be simply justified when the price is close to it, whereas overvalued instruments could go any higher as a bubble occurs. Roughly saying, you may predict, “it wouldn’t go lower than that”, although it’s much harder to say, “it wouldn’t go higher than that”.
Then, how can we short sell if it’s difficult to predict the peak of the bubble? This article explains what institutional investors consider in this kind of situation.
4 factors to think
When institutional investors consider short selling, they ponder on the following:
- The scenario of the price falling
- How long to short sell
- The maximum loss in case of failure
- The profit in case of success
We review these one by one. The first thing to consider is the scenario:
Predicting the process of the price falling
In order for the overvalued instrument to fall below the appropriate price, there has to be a significant event that can turn buyers into sellers, such as a bad earning release and a change to monetary or fiscal policies.
When George Soros short sold the British pound, he was expecting the UK government to give up supporting the currency at some point, and when David Einhorn short sold Lehman Brothers, he was expecting it to go bankrupt due to their losses in mortgage-related derivatives.
Meanwhile, the proprietary trading divisions of the sell-side firms such as investment banks, which are not the specialists for trading on the markets, seem to like betting on financial releases of companies before they disclose them, taking advantage of their close business relationship with the companies, which is, from a viewpoint of purely buy-side hedge funds, merely because of their lack of ability to speculate, but different people have different ways to invest anyway.
How to decide the timing of short-selling?
By the way, we can’t short sell forever, since short selling has a cost.
Firstly, there is a fee to borrow stocks. In order to short sell, we need to borrow stocks, and the borrower has to keep paying the lender as long as they keep short selling.
Secondly, if you short sell bonds or stocks that produce yields or profits, with all other things unchanged, the security price including yields or dividends automatically goes up. Every year, a bond produces an yield, and a company gains a profit and preserve it or make a dividend, which directly gives a loss to the short seller even if there is no change in the fundamentals such as P/E.
Therefore, when short selling, you must consider how long you need to short sell. George Soros estimated when the UK government would run out of the budget to support the pound, and David Einhorn considered when Lehman Brothers would really run short of cashflow so that they have to admit their unrealized loss in mortgage-related derivatives they didn’t properly add in their balance sheet. These estimations tell you how long you need to short sell.
You can short sell without knowing the peak of a bubble
Even if you don’t know the exact peak of the bubble, if you know how long to short sell, the room for the price to go up in the period will be limited. If it’s still difficult to predict, you may buy put options. In either way, it’s possible to short sell if the period is predictably limited.
The other things to decide are the profit you’ll gain if you succeed and the loss in case you fail. The more important is, of course, to calculate the loss. After you know the maximum loss, you can determine the size of your position.
Calculating the position size from the acceptable loss in the deal
Suppose you estimate your maximum loss in this short selling is 20%. In order to decide the position size, you have to know how much you accept to lose in case you fail in short selling.
If you are a fund manager who manages $100 millions and consider you may accept to lose 5 millions in this deal, as 5 millions should be 20% of the position, the position size will be 25 millions. If you only accept 1 million to lose, your position will be 5 millions. This is how you decide your position size from the amount of the acceptable loss.
Profit
After you decide the position size, now you can estimate your future profit you gain if you succeed. Nevertheless, it’s not the most important to calculate, because if you are a good investor and vaguely feel, “this financial instrument is so much overvalued”, and the possible loss is estimated to be an acceptable size, your position will be automatically sufficiently profitable.
The above is how a fund manager with a global-macro strategy short sells, and therefore an investor with a different strategy, for example technical analysis, might consider in a different way. The author wishes this article helps the readers short sell or predict a short seller’s future behaviour in the market, in order to squeeze them.