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TheStreet Open House

Blindly Shorting China Stock Yields Big Return

Stocks in this article: SHZ

In short, if SHZ is committing fraud as per the Absaroka allegations, they are doing a very poor job at it. Typically, fraudulent companies will inflate their revenues and deflate their expenses, trying to manufacture profits so they can raise money from U.S. investors. In the case of SHZ, its profit and loss is already so consistently dismal that I find it hard to believe the company is committing much fraud.

When the price recently jumped from below $4 to around $6.50, I jumped in to short SHZ again, but this time in a different way. I sold 1,000 $7.50 strike calls (i.e. well out of the money) at a price of $0.40, netting me $40,000 and my only risk was that the price would jump above $7.90 in the very short term. It was a no-brainer. I wanted to do a larger trade, but the price dropped quickly and the silly bid at $0.40 evaporated quickly. Unfortunately, shortly thereafter, all of the brokers increased their margin requirements on Chinese RTO stocks, including the requirement on naked calls. The stock fell to $4.50 and my broker required that I keep $450,000 as margin requirement against this position, so in terms of return on capital, it was not so great and I ultimately repurchased the calls at $0.10, so I only netted $35,000.

In retrospect, had I sold 1,000 in-the-money calls, I would have captured the entire $2 move and made $200,000 and the margin requirement would have been essentially the same.

As a result, this time I decided to take advantage of this latest pop to sell $2.50 strike calls (i.e. deep in the money). Because the options are deep in the money, this trade performs exactly like shorting the stock, but with the advantage that if the stock is halted (due to fraud or other concerns) the options simply expire worthless and I keep all of the premium received.

Once again, with performance this dismal, I don't think the company is committing a significant amount of fraud. If they are, they certainly are not doing it very well. I do note, however, that immediately after the fraud allegations were released, the CFO resigned "for personal reasons" and the company appointed a 29-year-old recent college graduate to take his place.

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