From the Financial Toolkit: Short Selling

In the previous blog post I wrote about the mechanics of options to help smooth out and reshape investment volatility.  In this blog post I want to discuss another investment tool:  short selling.

Short selling involves borrowing shares of stock and selling those borrowed shares.  This immediately does two things to your portfolio:  1) It gives you a liability for the shares, 2) It gives cash proceeds from the sale.

An investor, Alice, may choose to short a stock (or ETF) because she expects its price to fall.   She may expect one security  to fall relative to another security.  For instance, if Alice expects AAPL to outperform MSFT over then next six months, she could short MSFT and use the cash proceeds to purchase AAPL.  Even if MSFT goes up, Alice will make money so long as the value of her AAPL holdings go up more.

Suppose things don’t go according to plan for Alice.  For some crazy reason MSFT shares go way up, while AAPL shares remain flat.  As this trend continues, Alice’s portfolio net asset value (NAV) erodes.  This decreases Alice’s margin and increases her portfolios’ leverage.  If the trend continues Alice will eventually receive a margin call and have to cover her short position by buying MSFT stock to close her short position.

There are a few details to be aware of before entering a short position on a security.  The first is determining whether (and how much) stock is currently available for short-sale.  Once you’ve determined that your chosen stock is available for shorting, you should find out the particular terms for borrowing the stock.  For instance, you may forfeit a small percentage of your short-sale proceeds.  Often highly liquid stocks will be cheaper to borrow than less liquid ones.

Once you’ve found an stock with short-availability and an acceptable borrowing rate, you can execute a short-sale.  Since you will have a negative position (say -100 shares) you will pay rather than receive dividends on every share.  See also this helpful explanation of how, where, and why short-shares become available.

That’s the basics of short-selling.  Short-selling provides an alternative way to bet against a stock.  Buying puts is one method, short-selling is another.   Short-selling is allows going long-short… picking winners AND losers.  Short-selling is a tool that opens many investing opportunities and exposure to additional investing risks.

Options Investing

Some readers have expressed interest in options investing blog topics.  So I’ll pontificate a bit about options investing.

I view options as generally “zero-sum” hedging tools.   When I buy and sell (mostly sell) options my first thought is not making money on the options trades.  My main goal is transforming and reshaping my portfolio.

In my IRA portfolio option trades cost me about $8.00 each.  Since IRA accounts generally cannot be margin accounts, I have only 4 basic ways to play options: 1) write covered calls, 2) write cash-covered puts, 3) buy calls, 4) buy puts.

The tactic I’ve applied in my IRA is a basic covered-call approach applied primarily to SPY.  In a nutshell, I started by buying 100 shares of SPY and selling a single at-the-money call 2 or 3 months out.  That call option either expires worthless or I buy it back just before it gets exercised.  I then repeat every couple months; selling 4-5 option contracts a year.

The primary advantage of this approach is that it provides extra return during sideways markets and softens market dips.  The trade off is missing out much of the upside return during bull markets.  Setting the option strike price near the stock price eats into portfolio upside, but gives larger option premiums.  Choosing a higher strike price, more out-of-the-money, allows you to retain a larger share of market upside but provide you a smaller premium.

The other factor to keep an eye on is implied volatility.  The most common way to track implied volatility is via the VIX.  When the VIX is higher, you can expect to get more money for the calls you “write” (create and sell a call option).  I prefer to sell call options when the VIX is 18 or higher.

So if you are interested in dabbling with options I recommend starting with selling covered calls on a highly-liquid ETF like SPY.  Real time bid/offer quotes are almost essential and allow you to make limit order trades.  I recommend starting near the option midprice when selling a covered call.  For example if the Jan 2011 SPY 125 call has an ask/offer of 2.16/2.20, you can started by offering your call at 2.18. [Depending on the exchange, your brokerage account, and the price you may only be able to bid in $0.05 increments; in other cases you can price options in penny increments.]

To make things a little more confusing, most options are quoted with a 100x multiplier.  So that means that an option quote of $2.18 actually sells for $218.00.  Each option contract transacts 100 shares of the underlying security (the “underlying”).  So exercising one SPY 125 call contract requires paying $12,500 in order to buy 100 shares of SPY at $125 per share.

Year-End Portfolio Tax Planning

With only a few weeks remaining in 2010, now is a great time to make any tax-planning adjustments.

Step 1 is determining your general current capital gains and gross income situation.   Do you have carry-forward tax losses?  What are your current 2010 realized net short-term and long-term capital gains?   What are your unrealized capital gains?  What is your 2010 “ordinary income” situation looking like?

Answering these questions gives you a starting point for year-end tax planning.

For example, if you have big long-term capital gains because you sold a bunch of company stock to make a down-payment on a vacation property, you make ask yourself, “is paying 15% tax on these gains a good deal, or do I want to try to offset them with a few capital losses?”

Or, you may ask the inverse question…  “I have a bunch of unrealized long-term capital gains;  Should I sell now and realize them for the ‘bargain price’ of 15% tax?”

Some of these financial questions are tough to answer.  That is why I pay my CPA $80/hour to help me answer them. [This is a bargain price; my previous CPA was $150/hour.  Finding a good one for $80/hour was a godsend!]  If your struggling to answer them, I’d encourage you to set up an appointment with your CPA, or if you don’t have one a local CPA.   Bring your best answers or guesses, and you might be surprised how much they can enlighten you in one short hour.

A little year-end tax planning could save you $500, $1000, possibly several thousand dollars.  If you have to pay $80, $100, or even $250, for this I’d say its money well spent.

Portfolio Construction ETFs

Just a quick chart, globally-exposed ETF building blocks with VTI, JNK, IGOV, and  EFA.

GRAPH:  Possible portfolio construction pieces

And on the short-side, ETFs: BIL, BWX, IEI, IEF, ISHG, ITE, and TLO.

GRAPH: Possible short-side (deconstruction) pieces

These ETFs are building blocks I’m considering for a long-short portfolio.  As you can see it would be a US-equity-long,  global-equity long, high-yield (junk bond) long, USD (United States Dollar) short portfolio.

I’m also very interested in call option writing to blunt some of the equity exposure, whilst still remaining equity-long.

What Election 2010 Means for Your Finances

Simply put, the House will go to a Republican majority.  The Senate is likely to maintain in Democratic hands, though by a small margin (say 51/49, with independents caucusing Democratic).

Meanwhile, there will be a lame-duck House and Senate sessions.  The biggest item this Congress will face is expiring tax cuts.  There are two ways this can go.   1)  A compromise is reached before year-end where cuts under a certain number (say $400,000) are retained.  2) No compromised is reached and the tax cuts sunset.  Forced to bet, I’d predict option #2 happens.  If this occurs, this sets up an interesting 2011 where the President’s veto pen and the Senate are the checks against a strong Republican push to retain the Bush tax cuts.

In 2011 the status of income taxes, inheritance taxes, dividend taxes, and capital gains taxes is up for vote.  The strong Republican shift in the House will put more attention on these issues in 2011.  The minority status of Republicans in the Senate will make it challenging for Republicans to put significant changes on President Obama’s desk.  The biggest wildcard will be how President Obama will deal with this dramatically changed legislature.

In summary, I predict that the next 2 years will be marked by gridlock on many fronts.  I predict that the Bush personal income taxes will be retained for those with incomes $200-250K or less… I’ll hazard that even up to cuts for this with incomes up to $500K will be retained.  The fate of dividend tax cuts it less certain.  I suspect that the 15% rate will be retained for those with incomes up to $500K.  I suspect that capital gain rates will lapse to the higher pre-Bush levels.  These are my best guesses.

Computing Beta, Again

The beta computation saga continues.  I came up with a modified version of the example beta computation method from:

I incorporated a couple modifications (specific to Excel 2010):

  • Install the “Analysis Toolpak” Add-in:
    • File->Options->Add-ins->”Go…”->”Analysis Toolpak”
  • Data->”Data Analysis”->Regression
  • You will have the option of “R Square”.  You will have a couple coefficients, the first (top) is alpha, the second (bottom) is beta.

The “Babson Method” is equally effective.  Take your pick.  Beta and “R square” together are more useful than beta alone. Remember that a low R-square (say <0.5) means that (historic) beta is not particularly useful for explaining the movement of the stock or asset in question.  Moreover either method also supplies a (historic) alpha… a measure of that assets excess return versus the benchmark.

Like any backward-looking analysis, historic alpha, beta, and R-square provide ways to look a that asset’s past.  One hopes that they provide some measure of an asset’s future… this may or may not prove to be the case.

I still see a minor factor that makes either method slightly imperfect…. the lack of accounting for total return.   The basic method don’t account for (re-invested) dividends.  However this is fairly easily remedied by factoring in dividend payments into the asset returns.  It is likely that there are other refinements to be found.

Computing Beta

I will try to use as little math and jargon as possible…

Beta is one way to look at a stock’s behavior relative to the rest of the stock market.  The most common way to compute beta for a stock is to compare its price over a 3 year period versus the S&P 500.  The beta for a stock can be computed with daily, week, monthly or other data.  Generally the difference in the final answer is small between these.  Personally, I favor a beta based on daily closing values, but for this blog post I’ll stick with a monthly beta computation.

Lets compute beta for CSX versus SPY (an S&P500-based index EFT) using Microsoft Excel 2010:

  1. Go to Yahoo Finance and type in ticker symbol CSX.
  2. Click on “Historic Prices” and set the range from Oct 18, 2007 to Oct 18, 2010.  Select the “Monthly” radio button.
  3. Scroll to the bottom of the page and click “Download to Spreadsheet.”
  4. When prompted select “Open With -> Microsoft Excel”.
  5. Cut and paste the data in the “Adj Close” column to a new spreadsheet.
  6. Repeat the above process for SPY.  Put the SPY data in a column adjacent to the adjusted CSX closing price data.
  7. Compute the variance of SPY for example SPY data points e.g. “=VAR.S(C4:C40)”
  8. Compute the covariance of CSX with respect to SPY e.g. “=COVARIANCE.S(B4:B40,C4:C40)”
  9. Beta is, by definition, the value in step 8 divided by the value in step 7.  However I have found this not the case when using the MS Excel 2010 formulas above.  The next steps tell how I “fix” this beta.
  10. Compute average values for CSX and SPY: e.g “=AVERAGE(B4:B40)” and “=AVERAGE(C4:C40)”
  11. The fixed value is the result of step 9 *  the SPY average/the CSX average.  This is CSX’s 3-year, monthly beta.

Using this method, I compute a beta for CSX of 1.00.  This is a fair bit different that the value of 1.24 reported by Yahoo Finance.  I used the same process for MSFT and compute a beta of 0.93 versus Yahoo Finance’s 1.03 for Microsoft stock.  Looking for a more out-there beta, I repeated the process for C (Citigroup). I computed a beta of 4.39 versus Yahoo Finance’s 2.65.   For another comparison Google Finance reports betas for CSX, MSFT, C of 1.2, 1.05, and 2.54.  Finally, MSN Money reports betas of 1.21 ,1.06, and 2.55.

It irks me that 1) these 3 finance sites don’t detail their beta-computation methods, 2) They produce different results, 3) My method produces different results, 4) MS Excel doesn’t [I don't believe] offer a beta or function, 5) I have to tweak MS Excel data to get a more reasonable beta computation.

Be that as it may, I managed to explain one way of computing beta, and did so with a minimum of math.  Please feel free to flame this post and tell me a better way.  Until then feel free to try my method, or create your own modified method.

P.S. — I did some web searching and found an alternate method that is pretty decent:

They also perform a monthly 3-year beta computation. I like that it is clear, correct, and easy to follow.   I don’t like that it uses an older version of Excel and that it requires graphing and essentially reading the numbers off of the graph.

8 Questions to Ask your Financial Advisor/Manager (or Self)

  1. What is the average weighted expense ratio for all my holdings?
  2. How much, if anything, did I pay in commissions in the last 12 months.
  3. What was my rate of return in the last 12 months? (post all fees and expenses)
  4. How does that compare to the to rate of return in the S&P 500 in the same time period. (inclusive of dividends)
  5. What is the 12-month standard deviation of my investment portfolio? (a measure of risk)
  6. What is my asset allocation between stocks, bonds, and other?
  7. Do any of my holdings have loads?  If so why?
  8. How diversified are my holdings?

Bonus: Please update me on my portfolio’s tax efficiency and tax efficiency strategy.

Feel free to take good notes, and, if you like, send the answers to me.  I’d be glad to give you my personal assessment/opinion.