Thursday, January 16, 2014

The 180 Rule and shorting stocks.

This little essay is not to show how smart I am or to try to tell you how to trade stocks.  It is written for my favorite audience:  myself.  I decided to share it with you in case you have better ideas that you would like to share with me.  I also thought maybe, just possibly, you might benefit from my thoughts on the subject of shorting stocks, and my own creation, “The 180 Rule.”

What is a 180?

As a kid, I had almost no athletic ability whatsoever.  Too small for football, too short for basketball, too lazy for track, I stuck to what would today be called “X Games.”  I skied, surfed and most of all, skateboarded.  I had a cool plasticky board with double kick tails, called a Freeformer.  When you are skating along, and you completely turn 180 degrees in the opposite direction, you have performed “A 180.”  At least that’s what we called it.

So back to stocks for a moment.  There are two basic types of stock market portfolio managers out there today. Long-only, and long-short.  Long-only means the PM is trying to pick good stocks in his sector or market-cap weighting, to “beat the market.”  In actuality, most long-only funds are thinly veiled index funds.  Think of the Fidelity or American Capital mutual funds.  The biggest bets they make are to be slightly off in their weightings on a stock versus their benchmark.  They charge customers a management fee of 1-2% and that’s it.  If they make great returns by riding out a bull market and picking slightly better weightings than the index, then they benefit by advertising those returns and attracting more assets.  They actually have very little “skin in the game.”  It’s OPM (other people’s money) and they don’t get an incentive fee for doing well.  They DO NOT short stocks.  Their job: kind of easy. (Now I’m sure somebody reading this is getting offended right now, but you know I’m right.)

So what about equity/long short fund PMs?  They have a different whole game.  They charge a management fee PLUS they get 20% of the gains they make for their customers.  They have much more concentrated positions, and most important, they SHORT STOCKS.  Or at least they are supposed to – a lot of the lazy PMs simply are long-only funds in drag- they just short index ETFs against their longs and call it a hedge.

What is so great about shorting stocks?  Let’s think about this for a minute.  If I think I can beat the market through buying stocks that will outperform the general market, why can’t I also, while doing my research, find stocks that will underperform? In EVERY market, even 2013’s bull market, there are stocks that go down.  Industries, especially in technology, are affected by change and fortunes of companies rise and fall.

So isn’t isn't a lot of my research wasted if all I can do when I find a company that will decline is say “well, I just won’t buy that one?”  Also, think about this.  Let’s think about an ideal world in which during my research, I find 10 stocks I really like and 10 stocks that should underperform the market, or even drop.  Imagine how cool it would be to be long 10 and short 10 in equal proportion, so that I would have ZERO exposure to the vagaries of the overall market?  I could wake up blissfully ignorant of the level of the S&P, and just watch as my longs went up and my shorts went down.  What is my return on capital in this perfect scenario?  Almost infinite.

Or look at it another way.  I have $100 million to invest for my clients and I can’t take on any leverage, by policy.  I find my longs and now I’m stuck.  Wait a minute, I can still increase returns!  I can basically short as much as I want.  Any short idea that I find is essentially “Free capital” because it is opposite to my longs and does not give me more (net) exposure to the market.

I typically run 100% long, 35% short, to net out at 65% net long.  So in theory, I have less exposure to the market as a whole, but can make money both ways.  And I have!  Even in 2013, stocks like DLR, RAX, and IBM plummeted while the overall tech market went up.
So what’s the catch?

SHORTING STOCKS IS HARD.

That’s the catch.  It’s hard.

Most people, especially long-only people, do NOT know how to short stocks.

Shorting a stock is not the opposite of finding a good long.  You may want to long a stock with a low P/E but you most definitely cannot only short a stock because the stock has a high P/E.  Just ask investors in TSLA, NFLX, and AMZN how well shorting high P/E (high growth) stocks worked out for them.

A quick guide (10 ideas) on shorting stocks.
1. Don’t short on valuation alone.  Death, this approach.
2. Crowded shorts are subject to short squeezes.
3. When a short works, your position gets smaller so you have to press it.
4. When a short goes against you, your position gets bigger so you get punished more and more.
5. Accounting frauds are good shorts, but you still need sangfroid because they can go on for a long time before they blow up.
6. Smarmy managements can do a lot of things to mess with shorts, such as buybacks, puffery, raising the dividends, putting out bogus press releases, and reporting poor quality earnings.
7. Tech obsolescence shorts are great but sometimes take longer to play out than you think.
8. Whenever the market is up big with massive breadth, the long-only guys will buy the heck out of your shorts and you will underperform that day.
9. My favorite shorts are accounting issues, tech secular shifts which cause obsolescence, and bad managements.
10. You are always fighting the crowd when you are short because all of Wall Street is set up to make stocks go up and to tout them and to make up reasons why you’re wrong.

So what is the 180 Rule?

This one is so easy to explain that it will seem logically obvious to you.  You may wonder why everyone isn’t doing it.  So here it is:

“When I fundamentally change my thesis on a stock because of new information, which makes me decide to sell my stock, I should consider shorting it as well.”

Let’s dig further.  I own ACME Cool Tech Gadget Co. and I have been making money on the stock.  My thesis is that ACME has a great market position and that their new Gadget is going to be obscenely profitable or whatever.  Then, all of sudden comes some facts that prove to me that I’m wrong.  I am NOT talking about the stock dropping for no reason or for some other reason.  This is a key point.  If my thesis is intact and the stock drops, I may have to revisit my thesis, but this is not what I am talking about.  I mean, I have new information which makes me think, gosh, you know, I may be wrong here and I think I’ll sell ACME.  Fine.  Most people.  Wait, 99.9% of people at this point just sell the stock, book profits and smile.

Then, the next few days when the stock drops, they lean back and smile.  They might even have a glass of champagne or two.  Three months later, when the stock is way down and it is obvious that they were right, they are happier yet.

BIG MISTAKE.

If the PM sells ACME because they think it will go down, why didn’t they also short it?  Then they would make money on both sides.  Imagine the annual rate of return if a PM did this at least once in a while.  This is a critical rule for amping up performance.  Why doesn’t everyone do it?

BECAUSE IT’S HARD, THAT’S WHY.

It’s mentally so difficult to be so cerebrally flexible that no one does it.  A day ago, you loved this stock.  You had good feelings about it, nice warm emotions.  You know a lot about it.  You might like the products.  Maybe you met the management and they are a bunch of nice guys.  Hell, you even made money on ACME.  “ACME stock sure has been good to me.”  DISASTER.  Do you see how emotional you are?

“When the facts change, I change my mind.  What do you do, sir?” said John Maynard Keynes.

It is so hard emotionally to do this 180 that no one does it.

When I went back and analyzed my trading records over a few years, I would have dramatically improved my performance had I followed the 180 rule every time.

Does it always work? Of course, not.  No trading always works.  Only 55% of my trades were winners in 2013, even during a raging bull market.  So you still have to follow your stop-loss discipline.  There is no magic to this rule.

But know this:  you are not playing The Game to your fullest ability if you don’t follow the 180 Rule.

Notice how the rule says “consider” shorting?  I don’t always want to do it.  Here are some reasons why.  If ACME stock has gone from a 6% to a 12% position because I was lucky and brilliant and got the story right, I will usually cut the position back.  This is not a case of the 180 rule.  I’m selling even though the thesis is intact, only because of portfolio sizing.

Now sometimes you might say, “Well, I’m just going to a neutral on the stock, so I’ll sell it and leave the money on the sidelines for now.”

First of all, I don’t get along real well with analysts that are “Neutral” on stocks.  What are you, Switzerland? This isn’t politics at a tea party.  Do some work and get an opinion.  When people on Wall Street tell me they are “neutral” that is code word for either “I haven’t done the work” or “I have no courage.”  (I was going to say I have no b---s, actually.)

So if I’m long ACME and I’m getting a bit skittish, then I think to myself BEFORE I EVEN SELL IT, should I do the 180 Rule here?  If I answer to myself (I talk to myself a lot, at least in my mind) “No, I wouldn’t short ACME,” then I won’t even sell it.

See the power of this rule?  It not only helps you make money on shorts, but it helps you clarify your sell decisions in the first place.  I strongly believe THE BIG MISTAKE is selling winners too early.  For every time I have round tripped a stock, I can name times when I rode a stock to 2, 3, even 5 times gains.  Find good stocks, buy them and hold on to them, says Warren Buffett and he’s doing pretty well for himself besides eating at that awful steak house in Omaha.

THE BIG MISTAKE of selling winners too early can be mitigated by following the 180 rule.  If I told you that you HAD TO short every stock that you decided you wanted to sell, I guarantee you that you’d hold on to a lot more winners.

The Game is a perpetual mindf—k full of mental mazes and torrents of emotions.  Even if you use the 180 Rule, you will find ways to convince yourself that you are really selling a stock for some reason, when the truth is you are selling because the stock is down a lot that day.  It’s a tough game.  It’s OK to just say “this ACME is too hard.  I know I’m right but it’s too volatile for me and I can’t handle fighting the crowd on this one.”  In fact, after making a ton of money on Pandora (P) in 2013, I said this very thing and sold it.  I followed the 180 Rule- I DID NOT short it because my thesis had not changed.  I just did not have the constitution to fight everyone that said Pandora was expensive and how everyone else was going to beat them.  The stock went up 35% in the first 2 weeks of 2014 after I sold it.  I was right, but I don’t feel that bad, because I sold it because I was a coward. But at least I admitted to myself that I was a coward, so there’s that.

(By the way, the 180 Rule also works the other way around- if you are short a stock and cover, you should consider going long.  My best examples of this are NFLX and GME, both of which I was short in 2012 and was long all of 2013.)

If you found this helpful at all, or if you think its complete bulls—t, hit me up on Twitter.  I would love to hear your comments.  I am @dasan.

9 comments:

  1. Very interesting, if even only as a mental exercise to go through when considering closing a position.

    Tilson also exhibited this flexibility with Netflix, going short, then long when his thesis changed.

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  2. I would consider this strategy "bustin a fakie" when you pull a 180 you're still putting your strong foot forward. But, when you do a fakie....your weaker foot is forward. I grew up with Animal Chin and 1/2 pipes are what I think about. But, for a street skater. And ollie 180 would put you in the same stance. I'm only making a point of this because there are a lot of skater traders and mainly it gives some space to talk shit. So, yeah, I like semantics. But, on to your point! Which I do like, and have thought about.

    Second, this is Livermore's suggestion. AND. The fact that you came to this conclusion on your own, without mentioning it............corroborates his thesis. It took me forever to average up on trades. And RARELY do I immediately short after a long. BUT...........FREQUENTLY I will go long after a short. Immediately. You know the trades...........a big fat gap down etc....you know there will be a bounce. Might not be big......but, you know waiting for lower ticks will keep capital tied up, so you might as well make a run at the bounce. Even though its magnitudes smaller than the profit you pulled being short. Point is, it's quick, and generally, you make the same amount you would have by waiting for the stock to hit that "support" you saw.


    So....I would definitely advise utilizing that.

    Shorting is just its own beast. Generally. I don't try to pick on winners. And, in a bull market, I don't waste time with coal or gold names getting hammered. Precisely for the reasons you cited. Specifically #3.
    The other thing about shorting is the stock NEEDS to be in a bear market. By that...I mean, it's industry, or a secular trend you can fade. I'm a lone gun, so I can't spend too much time on any one idea, so the accounting thing isn't in my play book.

    So, generally. I just wait for a bear market to start picking on shit. But, deploying "free" capital is definitely something I need to learn how to utilize and your explanation was short and to the point and will add value. The reason I think most PMs don't is reason #3. Which brings up trade management. And, if you recall, one of Paul Jones' traders made a killing shorting gold all year long............and, to pull that off, you have to keep hitting it. Which is something that never came to me intuitively until you spelled it out.

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  3. Selling a stock because it is fairly valued and there is another stock that is a better buy is not the same as thinking the stock is a short.

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  5. One of my resolutions for the year is to learn how to short stocks. This is quite the tutorial. Thanks, Dasan.

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  6. The stock, bond, commodity and currency exchanges have been reduced to gambling dens whereby the more powerful traders with deep pockets move the markets to maximize their own profits at the expense of the remaining not so powerful players. The big boys have enormous money power to move the markets in the direction which results in maximum profits for themselves. They effectively use the media to lure the other players in the market to a position where they would incur maximum loss.

    The markets continue to rise till all short positions in the market are covered and the majority of traders move to the long side. Once this is done the market falls till all long positions are closed and short positions undertaken. Then rinse and repeat. The price mechanism has little to do with the actual demand, supply, fundamentals or state of the economy.
    www.marketoracle.co.uk/UserInfo-Akhil_Khanna.html

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  7. "First of all, I don’t get along real well with analysts that are “Neutral” on stocks. What are you, Switzerland? This isn’t politics at a tea party. Do some work and get an opinion. When people on Wall Street tell me they are “neutral” that is code word for either “I haven’t done the work” or “I have no courage.” (I was going to say I have no b---s, actually.)"

    There are thousands of stocks out there, and the vast majority don't have a major edge one way or the other (or are just blind beta and move with the indices)...why would you feel compelled to have an opinion on every one? It's much more straightforward to just pick out the few with favorable risk/reward setups.

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    2. Totally agree. My point is when it's a stock you have done work on you should formulate an opinion. If your opinion is the stock will only go up 10% and that's not enough for you, that's fine. But to have no opinion at all means you haven't done enough work on it. I assume every stock in your limited set that you actually follow you attempt to calculate a valuation. You don't have to trade every stock- some are too hard- as I mention- but have an opinion.

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