Screening stocks and exchange-traded funds for covered call writing and put-selling involves evaluating for fundamentals, chart technicals and common sense parameters. One of the issues that can impact a position we hold from time to time is short selling.
Short selling is when we sell a stock we don’t yet own. It is borrowed from our broker who lends it to us and then sells it. The proceeds are credited to our brokerage accounts as we now have an obligation to purchase the stock in the future to repay our broker. This is known as covering the short. We also must pay a fee to our broker for this transaction. The trade benefits when share price declines and loses when share price appreciates. Hedge funds are notorious for using this strategy as the leverage derived from generating cash for a small fee creates a potential for exponential returns for which hedge fund managers are well paid.
Advantages to the short seller
- Potential for large returns from a small investment
- Benefit in bear market environments
- Can be used as a portfolio hedge against market decline
Disadvantages to the short seller
- Dividends are collected by the broker (lender), not the short seller
- Risk is limitless if share price accelerates
- A positive development may trigger a short squeeze (a situation in which a heavily shorted stock moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the stock
What happened to Ambarella (AMBA) this week?
AMBA has been a high flier since its IPO largely as a supplier to GoPro, the wearable camera maker. On Friday, June 19th, short selling firm Citron Research published a negative report on AMBA triggering short sellers to take action and triggering a short-sale related circuit breaker to kick in when share price declined 10% from its previous day’s close. The implied volatility rose 27% to 70%, a one-year high. However, the put-call ratio remained even showing that investors were still undecided. Jim Cramer, on his Mad Money Show defended AMBA, claiming that it is an even better buy at these reduced prices.
Chart showing impact of short selling on AMBA
- 6/19/2015: Yellow field: Citron Research report made public
- 6/22/2015: Purple field: Short selling has major impact on share price
- 6/23/2015: Brown field: Share price recovery begins
Exit strategy opportunities
We MUST buy back options on 6/19 or 6/22. There is no doubt that near-the-money strikes have met our 20%/10% guidelines. Early contract strategies include waiting to hit a double (favored earlier in the contract) and rolling down. Of course, closing the long stock position and moving to another security is also available.
This is a rare, but obviously possible, scenario where short selling has such a major impact on share value. The SEC and FINRA are keeping a close watch on potential market manipulation situations but we, as Blue Collar Investors, must be prepared for all possibilities. For those who still believe in this company as I do, may decide to continue to write out-of-the-money calls as share price recovers. For members who feel that this security is now too risky, it is time to move on to another stock. Many of us have enjoyed wonderful returns with AMBA since it was priced in the low $70s. Let’s watch then price action, especially compared to the overall market, as we move forward.
52 Traders podcast from New Zealand
Podcast site, 52 Traders from New Zealand, is interviewing one trader per week for a year to help develop an elite investment style. I was invited to be of those to be interviewed:
Alan’s podcast interview
Link to show notes page:
New York area members: Save the date:
I was recently invited to participate in The All Starts of Option Trading panel at the New York Stock Exchange on Wednesday September 16th from 4:20 – 5:15. I’ll provide more information once I receive it.
Next live seminar
Negotiations on extending the Greek bailout will continue this weekend in the hopes of reaching a last-minute deal. A June 30th deadline debt repayment to the International Monetary Fund is creating global market turmoil. This week’s economic reports:
- The US economy contracted at a 0.2% annual pace in the first quarter, less than the previously estimated 0.7%
- Consumer spending was revised upward, though growth in imports offset rising exports
- The resulting trade deficit subtracted two percentage points from GDP in the first quarter. The consensus estimate for annualized second-quarter GDP growth is more than 2%.
- Sales of existing US homes rose 5.1% in May to the highest level since November 2009
- New US single-family home sales rose 2.2% in May to a seasonally adjusted 546,000 pace, the most since February 2008.
- US consumer spending grew 0.9% in May, the highest pace in almost six years
- Personal income was up 0.5% for a second straight month
- Personal consumption expenditures price index rose 0.3% for the month and 0.2% for the year
- US non-defense capital goods orders excluding aircraft, a key indicator of business investment plans, rose 0.4% in May
- Orders for durable goods fell 1.8% in May, affected by a 6.4% drop in orders for transportation equipment
- Durable goods inventories declined in May for the first time in two years
- The University of Michigan’s consumer sentiment index jumped to 96.1 in June from 90.7 in May, the highest reading since January
- Initial jobless claims rose 3,000 to 271,000 for the week ended June 20th However, the four-week moving average fell 3,250 to 273,750
For the week, the S&P 500 fell by 0.40% for a year-to-date return of 2.07%.
IBD: Uptrend under pressure
GMI: 5/6- Buy signal since market close of May 11, 2015
BCI: Cautiously bullish but still concerned over situation with Greece and how the markets respond. Until this is resolved, I am selling an equal number of in-the-money and out-of-the-money strikes but expect to get more aggressive once this matter is settled
Wishing you the best in investing,