Use a Basket to Short Stocks

 | Apr 30, 2014 | 2:00 PM EDT
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A rising stock market creates all sorts of temptation. The human urge and psychologically-intoxicating feeling from making money is very powerful and tempting.

Studies have shown that the chemicals released into the brain when money is made from an activity such as the stock market is very similar to the jubilant feeling addicts receive when using substances.  

Interestingly, a rising market doesn't only tempt folks to make money on the way up. Tempted by the quick gain, the appeal of going short a stock -- selling the stock first and then hoping to buy it later at a lower price -- also becomes elevated. After all, why wouldn't you want to short Amazon (AMZN) at 100x earnings, right? Because valuations can be rendering meaningless in a bull market. A multiple of 100 can turn into a multiple of 150 for no other reason than that the market has moved higher.

John Maynard Keynes said it best: The market can remain irrational longer than you can stay solvent.

The more irrational the valuation, the greater likelihood that the return to reality is greater. Short-sellers who made it through 2000 obviously made a killing.

Twitter (TWTR) shares are down nearly 12% pre-market as the company's growing revenue took a back seat to weak subscriber growth. Even with the decline, Twitter still commands a valuation of $20 billion. That's greater than Chipotle (CMG), which also looks frothy but at the least Chipotle is growing revenues, profits, and customer count.  

So it's likely that when the tide goes out, these New Age social media companies will be in for an awakening. If you choose to participate, however, I would recommend using a basket approach. Instead of just betting that Twitter or Amazon are grossly overvalued and being supported by fragile optimism, short a basket of stocks with a small allocation to each.

The basket can be formed quickly with names like Twitter, Amazon, Facebook (FB), (CRM), LinkedIn (LNKD), Netflix (NFLX) and Tesla Motors (TSLA). Only in a bull market can such a group of stocks command the type of valuations that these businesses command. But if you try and short one, you could get burned. Build a basket, allocate a little to edge and you could potentially create a decent hedge bet against a rising market.

 The economics of shorting is why I avoid the trade: capped upside at a 100% vs. unlimited downside (a stock could theoretically go up forever). However, shorting serves its purpose and if you are interested in the practice, I'd do it via the basket approach.

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