A Safer Way To Short Stocks

  PTLA M LL

Most investors don’t like to short stocks because shorting carries unlimited risk. This recently played out in a very bad way after a person shorted KaloBios Pharma only to see the stock move from $2 to $18 in after-hours as another investor bought a high percentage of the float.

Before You Short This doesn’t happen all the time, but it is not advisable to short low float stocks with a large percentage of your portfolio. The question becomes what is a good opportunity to short a stock?

If you are looking at a long term prospect, be sure you understand what the costs involved in the borrow are. Brokerages will charge a rate of interest based on the demand for shorting shares, we call that the borrow. The more people want to short a stock, the higher the borrow rate will be. This will eat into the total return of your investment, so makes sure you aware of the rate.

It might also be wise to look into buying a put instead of shorting the stock. The put will give the exposure you are looking for, but it will eliminate the unlimited risk. The put can only go down 100%, so you won’t have to pay $18 for a put that cost you $2… but you might be able to sell it for $18.

Shorting stocks or looking for downside is every bit as difficult as finding a stock that looks to be going up. In fact, there is a saying on Wall Street that stresses that it might even be more difficult than being long. They say “shorts do the most homework” which implies that they are deeper into the story behind the stocks than the longs. This is mostly true, and a great example of this is Whitney Tilson’s short of Lumber Liquidators (LL - Snapshot Report). He tested products for poisonous fumes, and I highly doubt those long the stock did the same thing.

The Secondary

One strategy for shorting stocks in a small time horizon, is playing the secondary offering. A company will hold a secondary offering to raise some capital or allow large investors to exit their positions. In most secondary’s, the company will announce the offering, then through investment banks they will gauge interest from the market. The bulk sale of stock is almost always done at a discount to the market price.

That discount is what gives shorts a good opportunity to make some quick gains. The longer term short thesis also benefits from the secondary offering when the company sells shares to raise capital for itself. This increases dilution and lowers earnings per share.

Leverage The Zacks Rank

Recent FilingsThe Zacks Rank looks at the change in earnings estimates, which many fundamental investors believe drive stock prices. When looking to short a stock that is holding a secondary offering, your best bet is to look for a stock with a low Zacks Rank of #4 (Sell) or #5 (Strong Sell).

Just because a stock is doing a secondary offering should not make it an “automatic” short. Take the case of the very recent secondary offering from Portola Pharma (PTLA - Snapshot Report). The company announced a mix securities shelf offering when they reported earnings on November 9.

After the close on December 3, the company announced the offering size of 2.6M shares and that it would price before the open the next morning. Demand for this offering was significant and the deal was upsized to 3.125M shares and was priced at $48.00, a discount of $1.38 from the previous close or about 2.8%.

Here is a graph of the stock from just before the offering to Friday afternoon following the pricing:

From this chart, it looks like savvy investors were building short positions around $50, and once they acquired enough shares the stock broke higher and the deal was priced. Sometimes an investor will short a large amount of the stock and fill the short with the shares they receive from the deal.

Portola Pharma (PTLA - Snapshot Report) is a Zacks Rank #2 (Buy) stock, so clearly this one would not be on the list of ideas to short as earnings estimates have been increasing.

A Potential Play

Macys (M - Analyst Report) is a Zacks Rank #4 (Sell) and they filed a mixed securities shelf offering on December 1. Today the stock was downgraded to Neutral from Buy at Goldman Sachs.

The deal size is not known and the pricing will happen after we know the size. Shares of this stock could be under pressure over the next several sessions.

I should also note that Kalobios Pharam also filed a secondary, raising $8.2M in a private placement of 280,170 shares. That means that deal when off around $29. Of course, this is not a stock I would want to be short given the small float and general volatility it has exhibited lately.

by Brian Bolan

- Source: http://www.zacks.com/commentary/64081/a-safer-way-to-short-stocks#sthash.0iio97my.dpuf