How to Short the Market Right Now

1. What’s the best way to short the S&P 500 right now, considering its volatility?
Dan: I approach short selling the way a value investor approaches buying: find stocks with huge disparities between price and intrinsic value. Only with short selling, you’re looking for stocks priced at least 50% to 100% above what they are worth, using conservative assumptions. You then sell short (or buy puts with distant expiration dates), and wait for catalysts to drive the stock down to or below intrinsic value.
For example, writing for Strategic Short Report, I recommended January 2009 $40 put options on Lehman Brothers stock when it was trading for $45 in April 2008. We were confident that Lehman’s intrinsic value was much lower than $45. We took 450% gains when Lehman fell to $15 in July 2008, expecting some sort of resolution that involved salvaging some equity value. Little did we know that authorities, after arranging an orderly buyout of Bear Stearns in March, would sit by as the broker collapsed in a disorderly bankruptcy that September. Lehman stock then fell to below 10 cents per share. This sort of crash of an individual stock can occur over the course of six months — especially if the company carries a lot of unaffordable debt on its balance sheet.

As for the S&P 500, the lowest-cost way to short it would be to sell short SPY, the S&P 500 ETF. If you’d rather use options to short the S&P, you can buy “at the money” or slightly out of the money puts on SPY. I’d stick to further expiration dates.
The S&P 500 is overvalued. It would take a resumption of investor fear to drive it down to, or below intrinsic value. Despite recent weakness, we’re not yet seeing much fear — at least not as much fear as we should be seeing, considering the horrible economic and regulatory environment. The vast majority of investors still think we’re in a new bull market.
The best estimates I’ve seen put the S&P 500’s intrinsic value somewhere in the range of 800 to 900. This range should go up over time assuming economic growth, and the “survivorship bias” of the index (i.e., companies like GM and Citigroup, whose market caps get obliterated, get lower weights, while successful companies like Apple get higher weights as they rally).
But for now, considering valuations, profit margins, and risk premiums, the S&P is likely overvalued by 25%. The S&P could easily fall to that range by 2010, 2011, or 2012 but there’s no way of knowing when.
2. Can I buy and sell put options from my online brokerage account, or do I need to use a broker?
Dan: Every good online brokerage offers options trading. You’ll just need to open a margin account. Your online broker should have all of the available educational tools. E*TRADE has worthwhile links to free educational resources on options trading here. The basics of the simplest options trades are not complicated. I like to keep recommendations simple.
3. Is there a minimum amount of money a person needs to short stocks?
Dan: From my experience, there is no minimum amount. Most likely, the minimum amount would be your broker’s minimum for opening a margin account. You need a margin account to sell short. Another way to limit the amount of money you commit to shorting would be to buy put options instead. You can get the same exposure as shorting, but with much less money involved. Each put contract gives you exposure to a short sale of 100 shares of stock.
For example, if you shorted 100 shares of a $20 stock, you’d have to borrow $2,000 from your broker in your margin account (the amount borrowed depends on your level of equity in your margin account), sell the stock at $20, and have the obligation to buy it back in the future. Your profit is the difference in the stock price between when you sell it short and buy it back, multiplied by the amount of shares you sold short.
If you used a put option with an asking price of $2 per contract, you can short the same value of shares ($2,000), but only risk $200 ($2 per contract times the right to sell 100 shares of the underlying stock). Profit potential is much higher, but so is the risk of loss. The way we deal with this in Strategic Short Report is to find stocks that we’re highly confident are overvalued, and look for put options with high strike prices and distant expiration dates. If the thesis isn’t developing as we expected after a few months, we cut our losses.

4. Is there still opportunity to short BP, what do you think is the best way to do this?
Dan: I would not recommend shorting BP at today’s price, because it’s likely undervalued. The only thing powerful enough to drive it much lower would be endless class action lawsuits, without any sort of negotiated cap on damages.
That’s not an outcome I would bet on. It’s certainly possible, but not likely. The U.S. government has an interest in keeping BP alive and functioning normally, so it can fund cleanup costs damage claims out of its future cash flow. The value of BP’s future cash flows — after adjusting for spill-related costs — is likely much higher than the current stock price (especially if over the next decade, average oil prices are north of $100 per barrel, which is very possible).
That being said, if you want to bet on the government and lawyers tearing the company apart in a foolhardy manner (which wouldn’t necessarily surprise me), it would be much smarter to buy puts rather than sell the stock short, because with puts, you can limit your risk of losses.

Dan Amoss
Whiskey & Gunpowder

June 17, 2010

The Daily Reckoning