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Minyan Mailbag: What Makes a Good Short?

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Editor's Note: Minyanville is a community of people who share an interest in fiscal literacy. As perspective is an important aspect of our daily routine, we share this exchange with hopes that it adds balance to your process.

John-

Regarding buying Vols on Financials and why a basket of stocks not the index.

I think the thing people miss when they are trying to start shorting is this: shorting is event driven for the most part. You can have a slow blood letting in a stock but it is much harder to make money off of that move because the options prices this in already, and if you are on margin you have dividends and interest on your debit balance.

So when shorting or buying puts, look for several things:

  • A chart with Hope in it, before an event. An event coming such as earnings.
  • Low historical volatilities, below 30%. It is harder to make money in a 45% to 60% vol stock because if you are wrong you are toast.
  • Low short interest and also, if you can, more calls than puts (dollar weighted), leaning the wrong way more hope.
  • Poor chart hitting resistance. Autozone (AZO( represented most of these things.
  • Ducks in a row, as Toddo would say.
  • Also have more than one position, (diversify). Several weak sectors.

Money management is the next step and is most important. No more than 2% of risk capital allocated to a position. And take off allocation in a systematic and disciplined way (know ahead of time when and how much you are selling... Discipline trumps conviction)

It has cost me thousands to learn these painful lessons. I am sure
the newbies will gloss over this like it means nothing but anybody
that really does it for a living will agree with much of it, or their
own version.

I know you already covered this but he seemed more like the individual investor not hedge fund type of guy, so I thought I would put it in more layman's terms

Minyan JE

MJE -

These are good thoughts. As you say, I have covered some, but let's go
over yours.

A chart with hope in it. I look for a chart that has had a slow grind up and is near highs. This shows complacency, an expectation of the status quo.

Buy cheap options. This is the essential ingredient. When you over-pay
for options, you must be really, really right to make money. When you under-pay for options, you must be really, really wrong to lose money. This more than anything is the basis of my trading (and it sounds like
yours).

Low short interest. When a negative surprise happens, the less "shorts"
involved the better for shorts will slow the decline. This offsets the
fact that shorts are more often than not right in the long run, but just
may be off on timing. The best situation is when a stock originally had
a high short interest and as the stock grinds higher they get squeezed
out so the short interest is low. A large mutual fund is famous for
"squeezing" shorts out of their names and then selling (paring their
position into it) some and trading around their position. I pay very
close attention to "reading the tape" in these situations.

And risk control is paramount. Diversification is a necessary tool, but
I would add one thing. Over-diversification is almost as bad: really
good risk reward trades should be over-weighted to lower (but still)
good ones. The ability to do this is a function of experience and price.

Thanks for your thoughts.

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No positions in stocks mentioned.

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