After a fresh wave of panic-buying, short-squeezes and speculative euphoria, a slew of tech stocks with sky-high multiples and/or shaky business models arguably look like compelling short opportunities.
But as recent trading action shows, there's no guarantee that overvalued stocks won't get more overvalued in the short-term, and shorts who don't manage risk well can be forced to cover positions due to margin calls, which in turn can lead said stocks to rise even more.
A solid majority of my trading gains over the last two years have come from shorts. And if I've learned anything along the way, it's that picking stocks that are set to go down over time is only part of the battle. Taking precautions to avoid getting blown up by sharp counter-trend moves or the occasional bad bet matters just as much.
With that in mind, here are some suggestions for managing risk when shorting volatile, high-beta, tech stocks that one considers to be overvalued.
1. Spread Out Your Bets
By and large, I avoid having any individual short position account for more than 3% of my gross exposure, and rarely does a position get above 4%.
This naturally lowers the payoff one gets for individual shorts that fall sharply, but it also lowers the fallout in the event that a couple of shorts rip higher. And in a market environment where it's not hard to find frothy stocks and it can be hard to predict which ones will likely squeeze, I think the benefits of the latter outweigh the cost of the former.
2. Spread Out Shorts Between Different Industries/Factors
Anyone who has spent a few days closely watching price action within the tech sector knows how much various types of stocks (e.g. the tech giants, chip stocks, SaaS stocks, solar stocks) are prone to move in tandem. This kind of correlation can lead a bunch of stocks that are seen as part of the same industry or factor trade to be simultaneously chased and/or squeezed higher. And that in turn is a good reason for short-sellers to spread out their bets between at least a few different industries/factors.
3. Maintain a Meaningful Long Book and/or Cash Holdings
This is pretty basic. If an investor is all-in short, this increases the odds that he or she will be forced to cover some positions due to rallies/squeezes, on account of failing to meet maintenance requirements.
Having a substantial portion of one's portfolio in longs and/or cash lowers the risk of forced short-covering. Moreover, if markets in general are rallying and one expects a reversal, then selling a long or two to shore up cash balances could mean selling assets at a favorable time rather than an unfavorable one and spell larger gains for one's portfolio when markets reverse (provided, of course, they do).
4. Don't Solely Short Stocks That Have High Short Interests
Some companies -- owing to high multiples, giant losses, ugly balance sheets and/or deteriorating fundamentals -- will inevitably become popular targets for short-sellers. While shorting such companies can pay off over time if they're truly overvalued, stocks that have a large percentage of their floats shorted are also (as recent market action shows) more prone to shooting higher due to short-sellers getting blown out of positions. For that reason, I think it's worth keeping a substantial portion of one's short book in stocks for which shorts are less than 5% of the float.
5. Take Some Profits When Heavily Shorted Stocks Get Crushed
Even if one thinks such stocks remain overvalued, it often makes sense to take some money off the table following a major selloff, given how such stocks are prone to seeing major short-covering-fueled rallies when market action turns. And if such a rally happens, an investor who previously took some profits on a short can re-up the position at higher levels.
6. By and Large, Wait for Rallies and Squeezes to Short
If there's a pending news event that an investor thinks is poised to drive a stock lower, then this might not be necessary. But otherwise, I've found it helps more often than not to be patient when it comes to entry points for shorts, waiting until bullish sentiment is high and/or a lot of jittery and badly positioned short-sellers have been washed out, to make a trade.
7. Tread Carefully With Quality Businesses That Have Improving Fundamentals - Even if They Look Overvalued
If a company looks poised to see demand inflect higher or significant margin/profit improvement, that's a good argument for thinking twice about shorting it simply because it has high multiples. At a minimum, it's worth asking in such situations what kinds of numbers investors are expecting a company to deliver and whether or not it's likely to meet or beat those expectations.
(This doesn't apply so much to deeply flawed businesses that are unsure to ever turn a significant profit. Rather, it applies to more legitimate/profitable growth companies that have been granted rich valuations.)
8. Be Cautious With Shorts That Have High Borrow Fees
There are two reasons for this. First, if a stock has, say, a 40% annual borrow fee, then making money shorting it becomes a race against the clock. Second, other short-sellers are more likely to give a short leash to a position that has a high borrow fee than to one that has a low borrow fee or none at all, which in turn spells higher squeeze risk.
9. Be Quick to Accept When a Short Thesis Has Been Disproven and Cut Losses
When dealing with assets that in theory present unlimited downside, I think it's especially important to be honest with oneself about when a thesis isn't playing out as expected due to macro, industry and/or company-specific developments.
When a stock that you're short rips higher due to unexpected positive news, I think it's worth asking whether you'd open up a new short position in the stock, knowing what you know now. If the answer is "no," it's probably best to cover and move on.
