Profiting from Falling Stocks: Short Selling Techniques

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Profiting from Falling StocksShort Selling
Techniques

• Chris Argyrople, CFA
• Concentric Investments

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Mechanics of Short Selling

• Crystal Ball says stock is going to drop, how do
  you profit?
• Answer Sell the stock short before you buy it,
  then re-purchase the stock later at a lower price
• How do you sell something that you dont own?

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Short Sale Mechanics
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Benefits Risks of Shorting

• Benefits
• Can Profit from a Stock Prices Fall
• Sell Stock, earning Interest Income (because you
  invest cash from sale)
• Risks
• Borrow can be re-called at any time
• No Limit to How High Stock Can Rise

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Long vs. Short Portfolio Mechanics

• LONG SHORT
• 10 Opening 10 Opening
• Neg. 50 5 Weight 15 Weight
• Double Down 10 Weight 30 Weight
• Neg. 50 5 Weight 45 Weight
• Total Loss Lose 10 Lose 20

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Risk Controls on Short Side

• Due to Double Down Problem, Shorting is
  Approximately Twice as Risky as Equivalent Long
  Strategy
• Possible Risk Management Strategies
• Mechanical Method Cover if you Lose a Set Amount
  Like 30
• Completely Diversify Wait for your Event

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Idea Generation on Short Side

• Areas Over-Financed by Wall Street
• In the Markets, the Promoters always win
• Venture Capitalists, I-Bankers, Brokers
• Company Management, Other Insiders
• Past Fads
• Bagel Shops (Entry Barriers??, Theme Restaurants
  (Rainforest, Planet Hollywood)
• Fuel Cells, Golf Companies, Roll-Ups, Linux
• Internet Browsers, Push Computing, B2C, B2B
• Satellites, etc.

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Idea Generation on Short Side

• Possible Screening Tools
• High Short Interest (Barrons etc.)
• Huge Increase in Stock Price
• Insider Selling
• CNBC Factor All Your Friends Talk About It
• Valuations
• Momentum Crowd Janus, Pilgrim Baxter etc.

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Characteristics of Good Shorts

• Good Shorts Opposite of Good Longs
• Bad Business Model (Give Product Out Free)
• High Debt Loads
• Deteriorating Fundamentals (Fading)
• Shrinking Fundamentals (Down Results)
• Valuations with Room on Downside
• Accounting Issues
• Bogus Management

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Timing on Short Side

• Pay Attention to
• Is Stock Price Rolling Over
• Cockroach Theory Are Other Firms in Industry
  Blowing Up?
• Changes in Accounting Policy
• Insider Selling
• Float
• Lockup Expirations

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Timing on Short Side

• Dont Short on Valuation Alone
• Valuation is a Necessary but not Sufficient
  Condition for a Short Sale
• Example Short Amazon at 4 billion Market Value
  the Stock Peaked above 30 billion
• What will spur a Change in Valuation?

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Technical Indicators

• Timing Hints
• How Does the Stock Do on Huge Down Days in the
  Dow or NASDAQ?
• If it is Strong, what is that telling you?
• Look for Changes in Investor Sentiment
• Example Amazon Investors Changing Focus from
  Revenues to Profits

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Tax Issues in Shorting

• Shorts are Always Short Term Gains
• Short Term Gains are 35 Federal Rate (for top
  taxrate) PLUS 12 Massachusetts
• Holding Period Doesnt Matter
• Dont Cover Busted Short they never resurrect
  themselves from the dead
• Consider Tax Breakeven Portfolio Impacts

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Short Squeezes

• What is a Short Squeeze?
• Large Percentage of Open Interest is Short
• Short Term Buyers Overwhelm Sellers
• How Why
• Short Covering Mechanical Risk Control
• Long Holders Recall Borrows to Squeeze

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Takeover Possiblities

• Always Evaluate Potential Takeovers
• What is the Risk that your Stock can be Acquired?
• Look at Potential Suitors
• Example Didnt Short Corel because RedHat had
  20 billion market cap, an operating system, and
  no applications software

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Chatrooms

• Should you Pay Attention to the Chat
• There may be good info in Chatrooms as Short
  Sellers post info to disseminate bad news
• Be Careful, but there can be good info

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Good Books Sources

• Financial Shenanigans Howard Schilit
• Asencio.com

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Read Into Wall Street

• Sell Side Analysts Provide Hints
• Examples
• Peoplesoft priced for perfection
• We initiate XXXX with a strong buy, at 15X 2005
  revenue
• Conservatively discounted back _at_ 15
• Initiate with a Hold Rating

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The Press Release Machine

• Too Many Press Releases are Bad
• Be wary when Investor Relations keeps telling you
  about the next press release
• RedHat 3 press releases / day for months
• RedHat one time they released the names of 8
  programmers on one of their teams
• Is the Culture Dependent on Press Releases?

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Investor Relations Stock Promoters

• Pay Attention to the Companys IR
• Legitimate Investor Relations Firms Morgan
  Walke, Financial Relations Board
• Morgan Walke doesnt take options
• Stock Promoters Get a List of ALL of the
  companies they have represented
• How many options do they have?
• Example Liviakis Financial Agribiotech

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Unproven Concept Stocks

• Dont Bite their Hook
• Needle-less Injection Systems
• The Hook Needle Market is Billions
• Hook 2 Every Diabetic Will Switch
• This company has no competition OR they are
  the market leader
• Reality
• Research will show tons of competitors
• How will they Sell it ?

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Beware of Laser Companies

• Point the laser at
• Hair if it grows, then it is a hair removal
  laser
• Paint if it peels, then it is a paint peeling
  laser
• Skin if it peels, then it removes wrinkles

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Chantal Pharmaceuticals

• Chantal Burnison, Founder
• A Doctor
• Partner in a Major LA Law Firm
• Invented a Skin Cream that Reversed the Aging
  Process
• Has Patents (costs 6 to pull a patent)
• Stock went from 1 to 20
• 32 Years Old
• Smoking Hot Appearance

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Canada Vancouver

• Be Extra Careful with Canadian Stocks
• Bre-X Discovered Diamonds in Asia
• Cant Really Verify this Independently
• Chief Scientist Fell out of a Helicopter,
• BY ACCIDENT
• Stock was Still Above 10
• Pay attention to the variable that matters is it
  the Diamonds or the Helicopter?

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Sources of Future Frauds

• Mining Companies Internet Gambling
• Cancer Cures Rollups Acquis.
• Aids Cures
• Bio-Terrorism
• Bandwidth
• New Operating Systems
• Encryption
• Energy this could be a big one

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Theres Always a Story

• Bre-X Diamonds in Asia
• Molten Metal Neutralizes Nuclear Waste
• Safe Sciences Cures Cancer
• Kendall Square Research Supercomputers
• Biopure Blood Substitute
• Agribiotech Seeds
• PlugPower Fuel Cells
• Pattern? Public Shareholders Get in EARLY

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Check Out Managements Past

• Where have they been?
• What happened to the stock price?
• Did they sell before they left?
• Why did they leave ?
• Who are they friends with?
• Try to get their lifes story this is
  generally not scripted

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Short Rebate a Function of Fed Funds Rate

• In 2001, Fed Funds rate was 6, so there was a
  significant short rebate
• By 2003, Fed Funds rate dropped to 1, leaving no
  room for a short rebate