Shorting the Market Like a Poker Pro

 | May 13, 2013 | 11:00 AM EDT
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During my senior year in college, I took a year off to go play professional poker in Las Vegas. Although the decision did not exactly thrill my parents, it was a great learning experience.

Playing professional poker is a great laboratory for developing the same skills needed to be a successful trader. There is a reason there always seems to a few traders or hedge fund managers in the last 100 players in the World Series of Poker every year. Patience, discipline, focus and the ability to calculate probability/win percentages on the fly are all traits I developed more fully while sitting at the poker tables in Sin City.

My primary game was $5/$10 or $10/$20 Limit Hold'em . I also played in many No Limit Hold'em tournaments and even managed to win a couple of the minor ones. Most No Limit players' favorite starting hand is always two Aces face down. This makes sense as it is the strongest starting hand and is a statistical favorite playing against any other hand one on one. I liked getting this starting hand as much as any other poker player, but it was never my favorite hand.

The problem with "Pocket Rockets", as they are called, is that you will win a lot of small and medium pots, but when you get beat or "cracked" with pocket aces, your stack of chips can take a major hit. They are also hard to get away from if the "flop" does not come down well for your aces as you only get this starting hand dealt to you one out of every 216 times.

I much preferred playing a 98 or 76 suited in back position with several players in an un-raised pot. The flop did not hit this hand very often, but when it did you could take a "monster" pot by making a straight, flush or other winning combination. In addition, when the flop missed your hand completely it was easy to toss this hand in the "muck" and move on to the next hand.

I use this same philosophy when shorting stocks. I have always thought shorting straight equity positions involved too much risk and too little reward. A stock can only go down to zero, but can easily triple, quadruple or go even higher on the upside. The cost of being wrong or early on this sort of position can blow a major hole in your portfolio if not managed well. One only has to look at the performance of some favorite short targets like Tesla (TSLA), Green Mountain Coffee Roasters (GMCR) or Barnes & Noble (BKS) last Thursday to see this. All of these equities gained 20% to 30% in just one day of trading.

I think a better strategy to play is to buy deep out of the money bear-call spreads on an equity one thinks is significantly overvalued. Let's take a look on how this would work on Tesla which I shorted in this way late Thursday after its huge run up to $75 a share. Initiating a bear-call spread on this equity for me involved selling a Jan 14 $40 call option while simultaneously buying a Jan 14 $50 call option for a net credit of $900 a contract.

I think Tesla is a fine company and seems to be running on all cylinders right now. However, the current stock price ($76.76 at Friday's close)  now gives Tesla, which is just starting to ramp up production, a bigger market capitalization than either Fiat or Peugeot. Both Fiat and Peugeot have been operating for decades and produce millions of vehicles annually. The stock has also more than doubled since the first of the year and went parabolic last week as shorts desperately tried to cover their positions pushing the equity even higher.

 If the company hits any manufacturing issue or other bumps in the road to becoming a major automaker, TSLA could see a substantial pullback. By initiating this bear-call spread strategy I will make $900 a contract if the stock comes back down below $40 over the next eight months. If the stock holds up without a glitch over that timeframe, I am out $100 a contract. This play reminds me of having that 98 suited; I probably will end up "mucking" this spread position but every now and again I am going to take down a "monster". I also do not have to right often to make this a very lucrative trading strategy over time. It certainly worked out well with Rackspace (RAX) which I highlighted as overvalued at $66 a share back in November and now trades at $40 even in the face of the huge rally we have had in the market over the last seven months.

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