No matter how much you think you know about investing, there are always lessons to learn that you never expected. One hit me the other day that is very much worth a discussion, because it involves protecting yourself when you make a bad trade.
In this case, I had shorted 500 shares of Education Management Corporation (NASDAQ:EDMC) at $16.75, because the company is being sued by the Justice Department for fraud — to the tune of $11 billion. That would bankrupt the company, and my research suggested the suit had a lot of merit.
It sounded like a straightforward-enough trade. But I made two mistakes with this short that I hope you can learn from without having to find yourself in the same situation with real money at stake.
2 Steps to Never Skip When Shorting
First, I forgot to set my stop-loss at 7% above the price where I shorted. I always set stops at that level to limit potential losses.
Second, I didn’t think to check the Days to Cover/Short Interest data. If I’d done that, I would have seen the Days to Cover had skyrocketed from 16 to 44. In other words, it would take 44 days of regular trading volume for all the short interest to cover. That’s a huge number, and it meant that a short-squeeze could be easily triggered.
I was very pleased with myself when the stock was trading at $14.50. But I got burned, because a short-squeeze is exactly what happened as the stock ran up to $20. Had my stop been in place, I would have been out with only a $500 loss. Now I was looking at a $1,625 loss, and it seemed like the price would go even higher.
What could I do?
4 Potential Position-Protecting Scenarios
Buying five EDMC Dec 20 Calls for $1.60 would only protect me above $21.60. That wasn’t awful, but it meant absorbing another $800 in losses. It also guaranteed $800 more in losses, even if the stock should fall again.
Buying the EDMC Dec 20 Puts for $3.60 was no different than doubling-down on my short in a very expensive way, and I expected the stock to go up, not down.
Selling five naked EDMC Dec 20 Calls for $1.60 didn’t help, because it would require me to buy the stock above $20 if it was, in fact, trading above $20 at expiration. It provided a minor hedge, but that wouldn’t be much consolation if the stock were trading at, say, $28.
Selling five naked EDMC Dec 20 Puts for $3.60 might help, as it would be great if the stock fell. I’d have the stock “put” to me at $20 and, when combined with the premium I collected, would allow me to exit the entire position with a $175 gain. If the stock rose, however, I would remain exposed on the short side, although my effective short price would be $20.35.
Combine the 2 Best ‘Options’ to Save a Losing Trade
I ended up creating a collar. I sold five EDMC Dec 20 Puts for $3.60, and also bought five EDMC Dec 20 calls for $1.60. No matter where the stock closed on expiration, I would either have 500 shares put to me at $20, or be able to execute the calls to buy 500 shares at $20.
So, no matter what happened, I was covering my short at $20. I also collected a net of $2 per contract, or $1,000 in the deal. Thus, my effective short price was now $18.75. I’d lose exactly $625 on the deal no matter what happened.
It wasn’t ideal, but it substantially cut my losses and, more importantly, didn’t expose me to further upside moves in the stock.
Except … there was a third mistake I’d made.
Beware of the Interest Trap
Shares to short were scarce, so even my gigantic broker could only find them if I was willing to pay 2% in annual interest to borrow them.
I agreed, not asking if that number could change. A couple of days after initiating my collar, feeling good about my brilliant move, my broker called to inform me that the cost of borrowing the shares had just gone up …. to 70%!
Not only that, but it could go even higher without warning.
There was no way I was going to pay 11% interest — another $920 — until my December collar played out. What a crushing blow.
I had no choice. Even worse, the stock was trading at $19. So I covered the short for a $1,125 loss … but then had to buy back the puts for a $420 loss and sell the calls for a $400 loss. Total donkey-kick-to-the-head loss was $1,945.
The lessons here have already been explicated. The only consolation was that I’d already made over $10,000 this year selling naked puts on certain stocks — a much better strategy, which I’ll talk about next time.
Lawrence Meyers is crushed to report that he no any longer has any positions in EDMC. Wah-wah-wah.