In the last installment of The Finance Professor, I explained the
- Earnings Announcements: In anticipation of an earnings announcement, short sellers will seek to position themselves in favor of an earnings disappointment or guidance reduction (see
"Beginner's Guide to Earnings Calls" or "Five Missteps to Avoid in Earning Season").
- Court Cases: There are matters of judicial decisions that can impact a company or several companies. My most successful short (and one from which I gained notoriety) was that on Martha Stewart Living Omnimedia (MSO). My thesis was that not only was Ms. Stewart going to be found guilty and sent to jail but her eponymous publishing and media business would suffer as a result. Another example: Research In Motion ( RIMM) was engaged in a
civil matter over patent rights with NTP, a privately held corporation. Early in the litigation, Research In Motion was an excellent short as it continued to lose court battles. However, once Research In Motion and NTP settled, Research In Motion made an excellent long. I have played Research In Motion both ways -- long and short -- with much success.
- Economic Data Releases: Macro-market shorts are often made in anticipation of an economic data release or data-related event, such as the monthly non-farm payroll survey,
FOMC interest rate announcements or GDP data (see "Five Things You Must Know About the Fed").
Index Arbitrage:This is the off-setting of a "basket" of stocks vs. a derivative, such as index options, futures or swaps.
- Convertible Arbitrage: Typically achieved by buying a
convertible bond or preferred stock and then short selling common stock or options (on a delta basis) against the convertible securities.
- Risk Arbitrage: Risk arbitrage opportunities exist when one company has agreed to or is in the process of trying to acquire another company. Since the deal has yet to be consummated, there will be a risk that the deal will fail, thus creating a
discount to the price of the target shares. In that situation, the arbitrageur will buy the target company and short sell the acquiring company. For example, Toronto-Dominion Bank ( TD - Get Report) has recently agreed to purchase Commerce Bancorp ( CBH - Get Report) for 0.4142 TD shares plus $10.50 for each CBH share. The arbitrage here would be to buy CBH and short sell 0.4142 TD for each CBH share.
- Pairs Trading: When the relative values or technical nature of two stocks have diverged this may create a trading opportunity. Some traders will refer to this as "mean reversion trading." What follows is an example of pairs trading. Below is a two-year chart of Abercrombie & Fitch (ANF - Get Report) (in blue) vs. American Eagle Outfitters (AEO - Get Report) (in red). The assumption is that the two stocks are closely related in terms of
fundamentals and business models, so they should perform relatively in synch with each other. However, as we see in August 2006, ANF was cheap relative to AEO. At that time, an investor would probably buy ANF and short sell AEO in anticipation of ANF rising relative to AEO over time. And that is indeed what happened over the course of the next year until finally, the spread between the two stocks' performance collapsed by August 2007.
- Short Against the Box: This was a frequently used strategy that took advantage of an old "loophole" in the tax code that has since closed. Under the old tax code, if you owned a low
cost-basis stock, you could sell the same company's stock but instead of selling your long stock you set up a separate short sale. This created a separate long and short in your account, thus avoiding the realization of a capital gain. You can still use the "short against the box" strategy for short periods of time so long as you comply with the related Internal Revenue Service (IRS) regulations. As an alternative, many investors now create a pair arbitrage to attempt to replicate a short against the box. However, the pair is not as precise in off-setting risk as is the short against the box.