The Perils of Shorting: A Real Life Example

Colm Fagan

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The latest entry in my "Diary of a Private Investor" is a cautionary tale on the dangers of shorting shares.

A Tesla Halloween Horror Story (Update 20 of "Diary of a Private Investor")

Short sellers are the whipping boys of the finance world. They borrow shares, then sell them on, hoping the price will have fallen by the time they have to buy them back and return them to their owners, many of whom are blissfully unaware that their shares were borrowed in the first place. The short sellers win if the share price falls; they lose if it rises.

There is a belief in some quarters that what short sellers are doing is morally wrong, that they shouldn’t be allowed to bet on share prices falling. I once shared that view. A series of events eleven years ago caused me to change my mind.

In 2008, St Patrick’s Day fell on a Monday. It was a bank holiday in Ireland, but the short sellers who chose that day to target the Irish banks were hard at work. In what came to be known as the St Patrick’s Day massacre, they short-sold the Irish banks, causing their share prices to collapse. Worst hit was Anglo Irish Bank, the poster boy of Ireland’s property boom.

Official Ireland went apoplectic at what it claimed were faceless, unscrupulous profiteers who had the effrontery to question the stability of the Irish banks. Regulators, politicians and bank bosses took to the airwaves, insisting that the banks were absolutely safe, that there was no need to worry.

The reprieve was short-lived. Within months, the short sellers were proved right. Anglo Irish went bust; the other banks went cap in hand to government, begging for bailouts. Their shareholders were wiped out. Taxpayers had to foot the bill for rescuing their depositors. The short sellers were the canaries in the coalmine who had warned of impending doom. If politicians and bank regulators had heeded their warnings a few months earlier, Irish taxpayers would have been saved billions.

This episode caused me to change my mind about short sellers. No longer the baddies, they were now the good guys; heroes, not villains. With the zeal of a convert, I was ready to short-sell companies I thought were overvalued.

Tesla, the electric car company, was a prime target. I had long believed that its shares were grossly overvalued and had backed my judgement by shorting it. By the end of May this year, I was feeling smug. For every 100 shares I had shorted since opening my first short position in the stock in January 2018, I had closed 83, pocketing an average profit of $25 a share. The other 17 of every hundred shorted shares still outstanding were now priced in the market at $185 each, and I was sitting on a paper profit of $122 a share compared with the average $307 at which I had opened the short positions. Looking back now, I don’t know why I didn’t close my short positions entirely when the price fell below the $200 target I had set myself some time previously. It’s too late now. No use crying over spilt milk.

The window of opportunity didn’t remain open for long. Soon, the price was back above $200. Now that the price was above my target, I decided to increase my short position again. For every 17 open shorted shares at end May, I added another 28 at an average of $242 a share.

At the start of last month, Tesla’s share price had risen to more than $240, but I wasn’t worried. I could still close my entire position at a profit, but that wasn’t enough for me: I wanted more. The results for the third quarter would be released in a few weeks. I was confident that they would disappoint the bulls and please the bears like myself. The market would realise that I was right; the share price would fall; I would bag a handsome profit and ride off into the sunset, my satchels filled with gold.

Except that things didn’t quite work out as I had hoped. The third quarter results were released after markets closed on Wednesday 23 October. I reviewed them briefly that night and felt vindicated: revenues were down 8% from the same quarter in 2018; operating expenses were down 16%, mainly due to an 18% reduction in selling, general and administrative expenses. Spending on research and development was also down, by a smaller percentage. It seemed to me that Tesla was behaving like an outdated industrial metal-basher that was fighting off bankruptcy, trying to squeeze costs as revenues fell. It was definitely not living up its billing as one of the world’s great growth stories. I thought the market would agree and that the share price would fall when stock markets opened the following day.

I got it badly wrong. The share price jumped more than $40 on Thursday and another $30 on Friday, the start of the Halloween bank holiday weekend in Ireland. There was no need for ghosts or ghoulies to make it a scary Halloween for me: losing $70 a share in just two days was more than enough to send shivers down my spine.

I still don’t understand why the share price rose so sharply after the results. I eventually concluded that other investors had interpreted the expense reductions in Quarter 3 as evidence of improved efficiency, not as desperate cost-cutting, which was my interpretation. Undoubtedly, the cost reductions transformed the bottom line: net income in the quarter was $150 million compared with a loss of $389 million in the previous quarter.

As an old finance man, one of my favourite sayings is “Revenue is vanity; profit is sanity”, so I should have been impressed by the turnaround in net income despite the fall in revenues. This time, though, I suspect the opposite is true, that Tesla’s failure to grow its revenues at anything approaching the rate needed to justify its current valuation will eventually bring the share price down to earth.

Its growth ambitions are not helped by the decision to cut spending on research and development (R&D), which for most businesses is the engine that drives future revenue growth. R&D expenditure was over $100 million lower in the first nine months of 2019 than in the same period of 2018. Tesla’s R&D spend is less than a tenth that of Volkswagen.

Tesla’s current valuation, based on today’s $350 share price, is $63 billion. That’s a lot of mouths to feed. In addition, there is the $13 billion owed to bondholders and the expensive share options to CEO Elon Musk and his top managers if the business succeeds. In order to justify that valuation, a mature Tesla would need to be churning out profits of €2.5 billion a year, after deducting interest payments on its massive borrowings. That’s a tall order for a company that lost almost $1 billion in the first nine months of 2019, much the same as it lost in all of 2018, and whose grand ambitions are not being backed by the necessary investment in research and development.

Based on that analysis, I think my wager is safe in the long-term, but I am haunted ever since that Halloween weekend by the quote attributed to the great economist (and keen private investor), John Maynard Keynes, who famously wrote: “The market can stay irrational for longer than you can stay solvent.”

www.colmfagan.ie

PS: Elon Musk enjoys sending consignments of shorts to Tesla’s critics when the share price rises after a results announcement. Elon, if you’re reading this, I have a 36-inch waist, reducing to 34 if Tesla’s share price goes higher.
 

Gordon Gekko

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Hi Colm,

Great piece, thank you.

In my view, the problem with shorting is that one can be 100% right, but one runs out of money before that manifests itself.
Gordon
 

Colm Fagan

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the problem with shorting is that one can be 100% right, but one runs out of money before that manifests itself.
Hi Gordon. First, thanks for the compliments. Much appreciated. You're absolutely right about money running out. As I noted at the end of my piece, Keynes recognised that a long time ago. I'm OK for the time being!
 

Sunny

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John Maynard Keynes, who famously wrote: “The market can stay irrational for longer than you can stay solvent.”

This is my favourite investing quote and pretty much sums up the risk that it often doesn't even matter if you are right. You still risk losing your shirt.
 

Andrew365

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Colm,

How much does it cost you to fund the shot position daily? i.e. is there a time limit before you are forced to sell because the funding is too large? What platform do you short on?
 

EmmDee

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Colm - Long Term Options are possibly an alternative for a short where timing is unclear. Options have a bit more complexity around their pricing (time value etc) so won't provide the same direct return. But they do allow a bit more breathing space if the price fluctuates
 

Colm Fagan

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How much does it cost you to fund the shot position daily? i.e. is there a time limit before you are forced to sell because the funding is too large? What platform do you short on?
Hi Andrew. I calculate the cost at around 0.8% a year (it's charged daily). Charges may vary between providers and investor type (I now have the title of 'professional investor' - I'm not sure it's merited!). No time limit before I'm forced to sell: I do daily funded spread bets. Obviously I'm forced to sell if I run out of money and can't meet the margin calls. My Tesla short is with CMC markets. I also have some historic positions with IG Index, but don't do new business with them. I hope that answers all your questions.
 

declan11

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Hi Colm,

Thanks for writing this piece. I don't like Tesla as I feel Musk is too much of a media man. And its the second mouse that gets the cheese.
I wonder why you choose to short any shares? I had thought you were looking for a relatively modest return of 4% plus inflation? Shares always have a tendency to rise in general over time so you are swimming against the current when shorting. I know its more exciting and rewarding when it goes right but I would find it difficult to do. Declan
 

Brendan Burgess

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Colm

That is a great story.

I have always argued that ordinary mortals like myself cannot pick winners. The corollary of that is that we can't pick losers either.

But in 2014, before the restructuring of AIB, the share price indicated that although it was losing money, it was worth more than all the big German and British banks. I posted about it here


But it was not possible to short them.

Then Bitcoin came along and I shorted that $14,500 in January 2018. In advance, I decided to cash out when it fell to $3,000. It came close to that. I felt clever but wondered why I had not shorted much more as it was so obviously overvalued. But then it rose again. It was very frustrating. It's at $8,500 now almost two years later and I still have the position open.

Then AIB again. Despite my firm belief that I cannot pick winners or losers, I heard that one of the main banks was going to cut mortgage rates significantly. I shorted AIB but it was for a very small amount. Ulster Bank cut the mortgage rates...and AIB's share rose. I should have cut my position immediately but did not. I later closed out at a loss. Of course, AIB's share price today is a lot lower so I would have turned a profit eventually.

Then Tesla. When Musk announced that he had agreed a deal to buy out the company, I sold it short immediately. So I sold it short at the peak. But I had no exit plan. I was laughing all the way to the bank until that results announcement recently. I thought it was probably still overvalued, but I had enough. I got out. I made a reasonable profit on the transaction, but I had been up a lot more.

Just to put these in perspective. My total money at risk was never more than about 2% of my normal long-term portfolio.

My Bitcoin and Tesla shorts were intended to be long term shorts.

My AIB short was intended to be a short-term one.

I don't think I would do a short-term one again.

I probably would do another long-term one but only for a very small proportion of my portfolio.

Just to add that I also had successful bets with Betfair on the Bitcoin price being below $5,000 at 31 December 2018. But I have lost all my winnings and a little bit more betting that it would be below $1,000 at 31 December 2019.

Brendan
 

Fella

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The unpopular opinion is that unless you have some information that the market doesn't you are just guessing and I said the same with Reinshaw and the same to Brendan with Bitcoin , it's just a gamble you have no idea what way Telsa will trade in the short term and you try to justify the price movement after it happens . Better to just admit you like a gamble and be honest with yourself because every short you take or Brendan is a coin flip your not going to profit long term and even if you did over such a small number of bets it would be too hard to attribute it to skill over luck .
You'll lose by the spread and commissions is my guess if you simulated shorts over infinite runs.
It's an unpopular opinion and people like to look at the stock market and read about companies for hours on end , I know zero about the stock market but have made a massive profit investing with zero research other than buying low cost broad market trackers , I could easily show someone my portfolio which is a sea of green and huge percentage increases and pretend I spent more than 10 seconds hitting buy but I don't. There's enough people trying to get rich quick I'm happy to get rich slow .

The perils of shorting is that half the time you win and have the time you lose , you might convince yourself you where right and double down and your on anothsr 50/50 bet , there's lads down the bookies doing the same everyday .
 

Colm Fagan

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I wonder why you choose to short any shares?
Hi Declan. I have a very simple philosophy: if I think a share is cheaper than its fundamental value, I want to buy it; if I think it's dearer than its fundamental value, I want to sell it. If I already have shares that I want to sell, it's an easy decision, but it's not so easy if I don't have the shares to sell. It's not too unlike being introduced to negative numbers when you're going to school: in your early years you learn "3 from 2 you cannot take". Later on, you learn "3 from 2 gives minus 1"!
I once had a naive view that the occasional short would add some stability to my return, and would leave me less vulnerable to a major share sell-off, i.e. if the stock market collapses, my short positions should do well. I've done an interesting analysis of my Tesla short position over the last 22 months, which indicates that that theory doesn't hold water, not always anyway. I might write about it sometime.
Separately, there's an important addendum to my note to @Andrew365 : if the share is dividend-paying, the short-seller has the additional cost of the dividend each half-year. Needless to say, this is not a problem as far as my Tesla short is concerned :)
Brendan, thanks for your additional insights. Short-term calls are always very difficult. In theory, I'm prepared to wait as long as it takes for reality to bite with Tesla. There's the reality check of the audited accounts at year end, something you don't have with your bitcoin bets. That's one of the reasons I wouldn't touch that bet.
 
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Colm Fagan

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The unpopular opinion is that unless you have some information that the market doesn't you are just guessing
You're right 99% of the time, but there are rare occasions when the market is blatantly wrong. Tesla's current valuation is one of those times (in my opinion, of course!). Its share price is almost all hype by people who know nothing about finance; they just think Tesla = green = good, irrespective of the price. I think the last few paragraphs of my article make a compelling argument for Tesla being grossly overvalued. If anyone can point to a flaw in what I've written, I'll be glad to listen to them.
 

Brendan Burgess

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Brendan, thanks for your additional insights. Short-term calls are always very difficult. In theory, I'm prepared to wait as long as it takes for reality to bite with Tesla. There's the reality check of the audited accounts at year end, something you don't have with your bitcoin bets. That's one of the reasons I wouldn't touch that bet.
Hi Colm

What is your exposure as a percentage of your portfolio?

If I go up the mountains for the day and find that in my absence the American government and Chinese government have publicly announced that they are selling all their gold reserves to buy Bitcoin and Bitcoin flies through the roof, I will have lost 1% of my portfolio's value.

Maybe I am being too conservative, but it's hard dealing with an irrational market.

I have pointed out elsewhere that if I had been tuned into Bitcoin and spread betting in the early days when it was $800 , I would have shorted it then and would have lost my bet and sat there astonished as it rose towards $20,000.

Brendan
 

Brendan Burgess

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There's the reality check of the audited accounts at year end, something you don't have with your bitcoin bets. That's one of the reasons I wouldn't touch that bet.
That is a really interesting point.

I know that Bitcoin is worth zero. But as there are no accounts or ways to calculate a value, it is not possible to prove it.

I suspect that Tesla is worth something. But I just don't know how much.

Brendan
 

demoivre

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The perils of shorting is that half the time you win and have the time you lose , you might convince yourself you where right and double down and your on anothsr 50/50 bet , there's lads down the bookies doing the same everyday .
When you understand the difference between trading and gambling on say horse racing you are well on your way to making money from trading.
My 4 trades this morning on FTSE futures resulted in

-4 points
-3 points
0 points
+15 points.

Do you get it now?
 

demoivre

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You're right 99% of the time, but there are rare occasions when the market is blatantly wrong. Tesla's current valuation is one of those times (in my opinion, of course!). Its share price is almost all hype by people who know nothing about finance; they just think Tesla = green = good, irrespective of the price. I think the last few paragraphs of my article make a compelling argument for Tesla being grossly overvalued. If anyone can point to a flaw in what I've written, I'll be glad to listen to them.
The fact that Tesla is , in your view, overvalued now doesn't mean it won't be even more overvalued in 3 or 6 months time. I saw it all in 1999/200 with technology stocks. Judging sentiment would have made you money on the way up and on the way down.
 

Brendan Burgess

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I saw it all in 1999/200 with technology stocks.
A very good point.

I checked at the time to see was there any way I could exploit the crazy valuations of technology stocks but couldn't find one.

I am glad that I didn't, as I would have been burnt badly as crazy valuations became even crazier.

Brendan
 

SlurrySlump

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I used to trade a UK utility share called Kelda. I noticed that there was a trading pattern of about 20p per week. I would buy when low and sell when high. Lots of weekly trades and lots of small profits. This was done on a T + 10 basis.
I then got the bright idea that I could make money by shorting it when it was high. So I was making money on both sides of the trade. This went on for awhile and then the market makers decided to adjust the price in to a new trading range and it all fell apart. Fun while it lasted though.
 

Fella

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When you understand the difference between trading and gambling on say horse racing you are well on your way to making money from trading.
My 4 trades this morning on FTSE futures resulted in

-4 points
-3 points
0 points
+15 points.

Do you get it now?
I'm not sure what you mean ? Your talking about trading the FTSE futures where I'm guessing your openning and closing positions quickly looking at signals and charts , it's not what I was referring to with Colm or Brendan , they aren't out to scalp the market and pick up a few pips here and there they are taking a decision over a longer time span.

I sat with a good friend of mine who is a professional currency trader and also trades Betfair , he thought me how to trade currencies but I just couldn't get it , he was in and out of the market all the time what I would call scalping a few pips here and there , with stop losses etc he was happy to pick up a very small profits and move onto the next trade. I've also tried and made money scalping racing markets myself , it is possible but its a different conversation to what I was referring to.

Congrats on your successful morning trading
 
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