Shorting In The Time Of ShitCos

HTZG, GME, now HWIN.  The more slandered or shorted or ridiculous the name is the more bullish it seems to be for the stock. Just imagine explaining this to an alien.

“I bought a deli for $100mm. It’s an investment.

A deli? Well… it’s a place where people from the surrounding neighborhood go midday for some protein stuffed into wheat…umm, no, not every person in the neighborhood. Just like some of them. Why not everyone? There are other delis I guess. And a McDonald’s. Oh, you have those too? Yea I love the fries myself. Ah, yes back to the deli. Right, so the deli actually has to buy the ingredients. Correct, it doesn’t grow them. Slaves? What? No, no, no. Those people are called “employees”. I have to pay them. And yes, that guy needs to be paid too. IRS. We call him IRS.

Did I mention it has the best dills?”

The entire shorting business model appears to broken. In a period where concentrated shorts are getting lit up, in a period where diamond hands combined with brick brains, shorting just looks like return-free risk. Or at least the style where you try to recruit support after establishing the short.

I think the game that is over is being short a stock and being loud about it, not shorting itself. The method of telling the world how smart you are just has to get more subtle.

— MultifractelFarol (@Mephisto731) April 19, 2021


I think @Mephisto731 is correct. Probably super correct. The best time to sell insurance is after the earthquake blows out your competitors.

You’re sneering. Fine, I’ll play along.


Common Objections To Shorting

It’s common for shorting detractors to mock the strategy as negative EV for 2 reasons. I’m just going to annihilate them now so we can get to a more productive discussion.

  1. Stocks have positive drift (aka “stonks only go up”)

    I get it, you are fighting the most fundamental risk premia. The “equity risk premia”. First of all, that’s debatable. After, all most stocks go to zero. Stock indices have risen over time thanks to rebalancing. But more clinically, the negative drift, can be offset by just offsetting the beta. You can short the target and get long a basket to sterilize the drift. So, in practice, and possibly in theory, this positive drift objection can be put to rest.

  2. Stocks have unbounded upside but limited downside

    This has no bearing on the EV of shorting. Anyone familiar with options understands that individual stocks have positive skew. If a stock is $100 despite everyone knowing that it is bounded by zero and infinity then the odds of it going down are the counterbalance. And the fact that most stocks go to zero is in keeping with that understanding. So, stop citing the unbounded upside as a reason why shorting is negative EV. Remember EV is a sumproduct of terminal prices and probability.

That said, shorting is no stroll in the park. We just don’t need to fabricate objections like the ones above to show that.


The Real Reasons Why Shorting Is Difficult

  • No limit to arbitrage on the short side

    First, think of the long side. I’ll paraphrase Sam Bankman-Fried’s explanation from his recent Odd Lots interview:

    If AAPL stock price went to $1 tomorrow, Warren Buffet or whoever would just buy the whole company. It makes billions of dollars in earnings and you could just buy all the earnings for less than the stock price if it got low enough. But on the short side, there is no mechanism to moor the stock to reality (although as we learned from the Archegos saga, a secondary to feed the ducks, has consequences).

    This lack of limit to arbitrage doesn’t change the EV of the stock which is already balanced by probabilities, but it does change the path behavior. You need to borrow shares to be short, and any share borrowed means a future buy order. So inflows of cash can cascade into forced covering since the short-seller is effectively levered.

  • The negative gamma effect

    I’ve explained this before with respect to shorting, but I’ll re-hash it simply. When a fund sizes a short it does so as a percentage of its AUM. Say the short is 10% of its AUM. You can think of the AUM as the denominator and the dollar-weighted short as the numerator. This ratio starts at 10/100.

    What happens if the fund wins on the trade because the stock drops 50%?

    Well, now the fund has made 50% on a 10% position, so its new equity is 105. Yet, the size of the short shrank with the stock halved. So now the numerator is 5, not 10 units. So the short is now 5/105 or 4.7%. The fund needs to more than double the size of the short to maintain constant exposure as a percentage of AUM. Both the numerator and denominator moved in a way that reduced the position.

    This looks just like short gamma. You need to sell more as the stock falls!

    When the stock rallies, the size of the short (numerator) increases, while the fund’s equity (denominator) gets hammered. Both forces conspire to force short-covering. Or buying, in a rallying market. Negative gamma. And to think, you often pay to borrow stocks, so you get the indignity of paying theta to play this game.


The Options Approach

Let’s address the ways we can use options to be short.

  • Synthetic shorts

    If you want to implement the short in the most similar way to a short stock position, then you will want to structure a “synthetic short”. Just like a stock position, it has 100 delta and no Greeks except exposure to cost of carry. But you faced that risk from the prime you borrow shares from anyway.  In this case, the borrow cost is embedded in the options but the clearing rate for that cost will be inherited from the arbitrageurs with the best funding rates.

    How to implement a synthetic short

    You buy a put and short a call on the same strike in the same expiry. To prove to yourself that it is the exact same exposure as a short stock position work through this example:

    Stock is $100
    You buy the 1 year 100 put for $10 and sell the 1 year 100 call at $10.

    The stock drops to $80 by expiration. What’s your p/l?
    What if the stock ripped to $120?

    The synthetic short will have the same path risks as an actual short so let’s move on to option strategies that mitigate the path risk.

  • Outright puts

    If short-selling seems like it has negative gamma, you could always substitute your trade expression with long options. At least, you get something for the theta.  So while you will be paying to borrow, it might actually be at a better rate than you can borrow from your broker. And the moment you buy the put, the funding rate is capped at the implied cost you traded at. If the borrow gets more expensive from that point forward, your put will actually appreciate in step with its rho.

    The risks of buying puts are familiar. You can be wrong on timing, vol, how far the stock actually falls. You can get middled. Your thesis can be right but not right enough.

    The benefit is you cannot lose more than the premium (unless you dynamically hedge…but if you are using the puts directionally then you shouldn’t be doing that anyway). This simple fact turns your strong hand into a weak hand. You always reserve the right to roll your puts down as you take profits or up to chase the rising stock. But the basic position, while risky, is path-resistant. And path is why shorting is so hard.

  • Put spreads

    Buying a put vertical (buy 1 put, sell a lower strike put, same expiry) sterilizes many of the Greeks since you buy and sell an option, including some of the borrow costs.  The tighter the strikes the more the bet looks like a pure probability play. If the strikes are wide, your further OTM will not offset the Greeks of the near put as much (if you think about it, an outright put position is the same thing as a put spread where the further OTM strike is the zero strike).

    If the stock has a lot of negative sentiment around it, depending which put spreads you choose, it’s possible you are getting a bargain if the put skew is especially fat.


Options and the “Write Down Your Thoughts” Effect

I’m not shilling for options here. I’m just pointing out that in a market that is scaring vanilla short sellers away, there are trade expressions that allow you to stay in the game at the time when you probably want to the most. Even if you decide not to use options, there is a benefit from walking through the trade construction process — it will tighten up your thinking. It’s like journaling.

Before choosing an option implementation, you should write down your answers. I’d be surprised if the answers to these questions didn’t impact how you might frame a vanilla short.

Let’s walk through questions you must answer before buying a put spread.

  • Edge: if the put spread I’m looking at pays 6-1 what do I think the true odds are? 4-1? 3-1? The amount of edge AND the fact that we are talking about a bet with a sub 25% hit ratio will dictate my risk budget.

  • Risk budget: How much am I willing to lose in premium?

  • Should I spread my risk budget over several months or is there a specific catalyst or expiring lockup that favors concentrating the bet in a single month?

  • Which put spread should I buy? Would I rather buy $1,000,000 worth of the 85%-80% put spread or the 70%-65% if $1,000,000 buys me 2x as many of the further OTM spreads. Or maybe I prefer a higher delta trade, that pays off more often but pays smaller odds. This forces me to think about price targets and the market’s relative implied pricing of those targets. It directs your attention to the meatiness or winginess of your thesis.

  • Does the winginess or meatiness of my thesis correlate to any other forces in the market or is it a purely idiosyncratic idea? For example, if you were interested in owning put spreads on a portion of the ARKK basket, then you could concentrate your put spreads on the subset of the basket that offered the best implied odds. Your thesis wasn’t specific to a single stock but more of a general liquidity trade.

  • How much dry powder do you want in reserve to roll your put spread up when the stock rallies? What thresholds would trigger rollups? Likewise, if the stock sells off, will you roll spreads down? How about down and out into a further calendar month? Will you roll down on a 1-to-1 basis (taking profits) or aggro win-big-or-go-home style where you use 100% of the collected premium to buy a boatload of further OTM put spreads?

Working through these questions refines your thinking and creates a plan for different scenarios. I find that the granularity of options and layers of relative pricing force me to “write down my thoughts” in a way that delta 1 trading can easily gloss over.


Conclusion

Short-selling is hard. Not because it’s negative EV, but because limits to arbitrage and the reality of levered return math create perilous paths. Whether the bruises from the recent mania will usher in a “golden age of short-selling” remains to be seen. But removing an entire direction of returns from your arsenal seems short-sighted. It’s a surrender to the current moment just when you should be thinking hardest about profiting from names that on a long enough time frame will have prices that match their ShitCo status. Options provide a more path-hardy set of trade expressions and may become table stakes for investors (ie hedge funds) whose mandates should not allow them to ignore the short side.



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