Nikola Inspiring Interesting Discussions about Short Selling
Truck maker Nikola’s IPO that launched on June 3 has been red hot, doubling in price already. The amount of short interest in it is causing concern for some people though.
When people invest in an IPO, they often do with high expectations, perhaps remembering some famous ones that ended up being moon shots, the kind that people may have had an opportunity to get in on the ground floor and passed up and find themselves regretting it later.
Some IPOs do deliver on these dreams, but most don’t, and a lot of them are like aircraft that try to take off but instead crash at the end of the runway, unable to get enough air under their wings to provide enough lift.
Others may take off nicely but run into a lot of turbulence once they get in the air and end up stalling, and when an airplane stalls that means that they are in the air and lose the air under their wings and lose altitude precipitously.
A lot of investors are so excited by IPOs that they do not even bother thinking about what they are doing before investing, and these shares are handed out like candy to a brokerage firm’s top clients, who greedily snatch them up with glee. The fact that the reality may not end up corresponding very well with their pipe dreams may serve to dim the outlook somewhat, but the world of IPOs is still very much driven by hype, and hype and investing really don’t mix that well overall.
IPOs are baby stocks in a sense, being so young, and we do protect them like we might a baby by coddling them with rules that are clearly biased toward the long side. We might think that this is appropriate, and exchanges and regulators do have a bit of a long bias anyway, but it may not be so fair or appropriate to place constraints on trading because even if we want to benefit one side or another, you can look to suppress market forces for a while, but this is not sustainable.
We instead need to work hard to maintain as neutral of an approach as we can, and especially realize that the goal with providing the means for people to exchange stocks should not to be to take sides, and ideally, markets would maintain as much neutrality as possible. Exchanges play the role of referee here, and if a referee takes sides, you won’t see a fair match.
IPOs go through a gestation period, where among other things, shareholders from the company are not allowed to sell their stocks until the appointed lockout period, from 3 to 6 months generally, comes to an end. Meanwhile, many of these locked out shareholders are chomping at the bit to sell, and aside from this approach running counter to the reason public stock exchanges exist, to facilitate trading, the value of the shares in an IPO in the first few months need to be designated with an asterisk at the very least.
We could think of this as a brawl in an arena, where we freely let in all those who wish to buy and provide upward pressure to a stock’s price but hold back a lot of those who want to sell. As the fight is waged in the gestation period, we’re not even sure how big or ferocious the mob of people kept outside of the battle is, because there really isn’t any way of knowing any of this until we finally open the doors and let them in and see what sort of stampede results and how this affects the battle going forward.
Whether this is an appropriate tactic or not, it does need to be accounted for, and anyone who is unaware of this risk and therefore does not attempt to manage it is actually acting without due care at the very least. No matter how long you may wish to hold a stock, this never should be seen as a license to be careless and even reckless, even though so many don’t get this.
You might be happy to put your ship on autopilot, but there may be obstacles along the way that should be avoided, and while your hull may be able to withstand the blows that you take when you aren’t interested in altering your course for anything, striking things and taking on water when these things can be avoided slows you down and accepts a lesser fate than otherwise without having these risks offset by benefits, given that there aren’t any.
To do well in an IPO takes a particularly skillful captain, as their much higher volatility than you find with your average stock play requires that this volatility be managed, with the seas being so choppy, where you have to be on the bridge and keep your eyes open rather than be content to nap in your cabin.
This involves more than just being aware of when the lockdown period is approaching, even though that’s one of the bigger icebergs out there, and this certainly needs to be on everyone’s radar. You can buy and hold these things like you can do with any stock, but whether you should want to is always another matter entirely, and this is especially the case with IPOs given their greater risk.
Many view volatility simply in terms of risk, where the goal is to avoid going too far into the red with a position, but avoiding investment losses is just one part of the broader goal of trading efficiency. A stock may end up a little higher over time after a rough ride up and down along the way, and we might congratulate ourselves for hanging on and pocketing this small gain, but this can yield results that are far from optimal, results that are soundly beaten by those who seek to trade the stock more optimally.
People hear nonsense such as that you can’t optimize your investing and the most you can do is just jump on board and hang on and hope, but the people who tell us this actually have no idea how to invest optimally and just assume it can’t be done. These beliefs are a huge obstacle to investors helping themselves, and what gets thrown under the bus with this attitude is not just the opportunity to manage potential losses, it is the abandoned opportunity to use optimization to seek out better gains that stands out the most.
We can use the last year’s performance of the S&P 500 to well illustrate this, although we don’t need a crash to improve our performance through sound position management, as there are plenty of opportunities to better optimize just by paying attention to what is going on with your positions. The goal here is a simple one actually, to be long when it makes sense to and not be long when it does not, instead of just ignoring circumstances and taking a much more obstinate view of investing.
Sound Investing Requires Situational Management
In spite of the 2020 crash, the S&P 500 has now recovered to where it is now up 8% year over year, thanks to the 42% rally since the late March lows. There are two elements that stand out here, the drawdown risk that we usually point to when we refer to risk, and the risk of your approach falling well short of optimal, and there’s nothing optimal about being thrown in the dungeon like we saw and hoping you escape relatively unscathed.
More optimal trading involves both, and more optimal trading does not need to involve sophisticated methods and we can even come up with some simple rules that will have us both more protected against big drawdowns and also seek out better profits during more volatile times when we should be more actively managing our trades.
The fact that these crashes come back in time, and especially when they do so in such short order, should not be any solace for investors. You can shield yourself from losses by just turning a blind eye to this, but you cannot prevent the real cost that this approach endures, the opportunity cost.
Whenever we ride a position down a lot, we may not lose in reference to some future price that we sell at, a point where we may fully recover from the drawdown and then some, as just being in a position that is losing so much, even temporarily, involves opportunity costs that are fully real and completely enduring.
Investors that lost significant amounts during the crash where they could have instead stepped away from their long positions lost money they will never get back comparatively, and in fact, the opportunity here was to limit these losses when things were so obviously grim, exiting their positions when things turned sour and re-entering when this sourness faded.
Our success can even be measured directly by calculating the difference between where we exited and where we got back in, where we got back in lower, with our direct profit from the move consisting of how much lower the price was when we got back in. There’s also the positive opportunity of being in something else that actually gained during this time, whether that be bonds or even being on the short side during these times.
It’s just as easy to short the market as it is to go long the market these days, and while this used to require a futures account, we now have inverse ETFs that do this for us that we can buy and sell them with a click of a mouse in our normal investing accounts.
Most people take a dim view of shorting, and it is because most people don’t have much of an idea about either shorting or going long for that matter, and just follow the advice of people who have a vested interest in their maintaining their funds with them in long side investments. To avoid the risk of your taking your money elsewhere, they tell you to stand fast and preferably not do anything but keep their money right where it is, with them.
Given that there is such a long side bias to stocks, with most people rooting for stock prices to go up, this is going to guide things most of the time, but not always. Shorting is a terrible blanket strategy for playing stocks long-term, but it does have its place and time and that place in time is when things are decidedly negative, where the chances of prices declining over a given period is significantly higher than their continuing to go up.
There are two things to look at when seeking to decide what the right thing is to do, although the first and most crucial step is to care enough to want to have your hand on the wheel to guide your ship in the first place, otherwise you’ll be sailing without a course and doom yourself to go wherever the winds may blow.
We can call these two factors that affect the way we need to steer our ships as direction and magnitude, and it’s actually the magnitude that is the more important of the two. Driving your car down a fairly straight road may take many minor adjustments in steering, movements that really aren’t meaningful, and you may even be able to take your hands off the wheel and still keep your car between the lines.
When you come to the bigger curves in the road though, these are the ones you really need to pay attention to, and the ones that can really benefit from our keeping our eyes on the road and seeking more control of our car.
This is where the added volatility with IPOs comes in, and the road that they travel down in this phase of their life can be a particular windy one indeed, seeing you all over the road and even in the ditch if you aren’t careful.
IPOs may be more organically desirable than mature stocks, but this side of the phenomenon tends to be overrated. To get the most out of these plays, we need to manage them better, and this is what really drives both returns with these stocks as well as having their higher downside risk be better managed than a passive strategy does.
The degree of management that we are willing to provide is going to depend to some degree on our desired holding time, but we never should be using this as an excuse to make decisions that are bad on any timeframe. How long we should hold should never be made arbitrarily, as stock performance doesn’t rely on our personal preferences and will often conflict with them. It makes no sense to hang on to a bad position just because you’d like to hold longer.
Those who rode Nikola on the long side and manage their trades pretty tightly are already out of the stock, even though it has doubled its IPO price even after the pullback it just suffered. The 25% that it dropped from June 9-11 is more than enough to chase a lot of traders away, who would have been out well before this big dip took us too far.
We Need to Pay Close Enough Attention to the Landscape of Stocks
This does not mean that still holding it is necessarily wrong, and this is where preferences do come in, where some may wish to let this ride some more to see whether they can book some better gains. 25% is a pretty big loss of altitude, but not enough to say that the fun is necessarily over, even though Nikola’s performance of late does suggest that it may have reached its cruising altitude for now and therefore the upside may no longer be enough from here to justify the risk.
July 10 was the stock’s first losing day though, and when we set aside whatever preferences we may have for holding longer, seeing this drop from almost $80 the day before to $70 should have been plenty for us to want to sit things out for now. This need not even require skill to manage, as a 10% trailing stop would have us out around $72 for instance, an approach that requires no judgement at all.
People very often hold on to these plays too long due to greed, and the greedy with stocks get punished too often because this is defined as staying around too long when the probabilities have turned against you. Otherwise, it would be wise to hold and this sets aside any considerations of greed, as it is being so greedy that you do the wrong thing that is the problem.
While some may not want to trade their investments on such a tight regimen, even though it may be more correct and optimal to do so, we do need to still be paying attention and acting when it is clear that we need to regardless of our preferences, and this applies much more so to IPOs than with regular stocks.
One of the things that we want to become confused over is looking at the privately issued price of an IPO and measuring its progress from there, instead of measuring how it has done since it began trading publicly on an exchange.
Royalty Pharmaceutical is a clear example of this, where it is being touted as a very hot IPO by virtue of its being up 50% in its first day in the market on Tuesday. The privately issued shares that were handed out prior to the stock debuting were priced at $28 per share, but these things are often intentionally underpriced and this was clearly a case of this.
The stock opened up in public trading at $44, and had a far less than exciting first day, rallying late in the day to get even instead of being up this fictional 50%. This is real enough for those who did obtain the shares privately, but the idea with measuring these things is to show how these cars do on the road and not just in the showroom. They hit the road the moment that they are offered to the public and not before, and it is the public’s response that needs to be measured if we want to get an idea of what to expect.
If anything, big gaps up from the private price run counter to our objective of capturing understated value, just like your wanting to buy a stock when it opens tomorrow and seeing the price leap. This gap does represent bullishness already expressed, which does take away from these opportunities more than seeing the stock do its rising at a time where the gains could be captured. Whatever potential upside the stock has, this gap has to be subtracted, making it at the very least less bullish than it would be without the gap.
The 327% gap over its private issue price didn’t scare Nikola investors, and big gaps therefore aren’t reasons not to jump on these, they just require even more care and attention. While we need to take account of this, it is only for risk management purposes, and we certainly do not want to use this calculation to measure performance.
Otherwise, you could have bought an IPO that gapped up like Nikola has when it first hits the market, lose half your money, and somehow think that the stock is still hot because it’s up 160% from its issue price. Issue prices are just as much of a distortion as looking at what the stock was worth privately a year ago, it just doesn’t bear any relevance to its performance in the market, what the people think about it.
The financial media makes this mistake all the time though, but we do need to keep in mind that their understanding of all matters related to stocks is at the superficial level. We’re seeing them make remarks about the risk of short interest in Nikola as well now, in a way that is quite amusing and is worth looking at.
They start by claiming that Nikola has a lot of short interest, 5% of their float, and this should really concern us. They point out that this is almost twice as high as the average stock in the Dow, without explaining why the Dow would serve as a valid comparison unless you are purposely looking for a group of stocks with a particularly small amount of short interest to try to make your claim look more credible.
5% is actually a low amount of short interest compared to a lot of stocks, the ones that move enough to attract a lot of short sellers. Tesla, for instance, still has 20% of their shares lent out to the short side, and this used to be much higher and has dropped this much due to so many short sellers getting clubbed to death by this stock’s meteoric rise over the last year.
Stocks that are actually under attack on the short side can have half or more of the float out short, and as far as the bulls are concerned, short interest itself is bullish because these shares will need to be bought at some point and is unexpressed bullishness, where the act of shorting itself, adding to this amount is the bearish side.
It’s hard to imagine a worse stock to be shorting, ever, over the last year during Tesla’s recent moon shot. It’s not that Nikola has been all that great to short either, and maintaining its strong performance will in itself serve to keep most of the potential short sellers on the sidelines.
There is also an additional market with shorting in addition to the market for the stock itself, the market for borrowing the shares. This market for borrowing is also subject to the laws of supply and demand, and only shares held by brokers can be loaned, meaning that all those shares in lockup don’t get to participate.
While the percentage of shares shorted is only 5%, the reduced supply even at this relatively lower level can cause borrowing rates to become very high, like the 240% annual interest that you have to pay now to borrow Nikola shares. This also serves as a significant limitation on short interest.
They claim that this 240% shows us how risky short selling is in general, not allowing themselves to be restrained by simple logic as a single stock cannot be representative of stocks in general. You do pay a premium when you short a stock, but nowhere near this extreme normally. We are thankful though that people are talking about this sort of thing since it does matter and this may not be as transparent to investors as it should be when the rates are much lower but still need to be accounted for.
We do need to realize that while interest costs do add to the risk in a short trade, this can be well worth paying provided that the potential for reward is high enough. The wise use of short positions confines them to opportunities notable enough to make the trade made sense, and not just shorting on a lark without enough of an advantage.
The oddness of this view though is that this purportedly huge short interest in Nikola is something that both sides need to be wary of, both the bears and the bulls, and it’s particularly interesting why they think that the bulls need to be worried about this too.
It’s not hard to figure why it’s risky to be short a stock that is rising so fast, where it doubled this quickly and may go even higher. Having a lot of short interest in a stock being a risk to bulls though just doesn’t make sense, although there actually is a real risk to the long side related to shorting that we do need to be aware of.
The claim out there is that this 5% short interest has misrepresented bullishness, where the gains in the stock price are artificially elevated by this short interest. That’s actually the exact opposite of the truth though, as the effect of short selling, by its nature, serves to depress prices.
What we need to be looking at instead is how the low amount of short interest might hurt the bulls, especially when they open the doors and the market for these shares expands greatly. This will bring the price of doing this down a lot and encourage more short selling, additional supply out of nowhere that would cause downward pressure on prices.
This isn’t going on now though, and we want to wait until we see real monsters and not just conjure them up. If not for the huge interest costs, shorting it here wouldn’t be too terribly unreasonable actually, as long as you defined your risk tightly enough, like above the high of Monday.
This very high rate, almost a percentage a day to have this stock out short, isn’t out of the question either. The way that Nikola is moving, you can make a lot more than a percentage on a given day if you pick your spots well. This is not a game for investors though as it requires a level of skill way beyond theirs.
As far as being in long right now, Nikola is looking a bit too muted now on the reward side to justify the higher risks, and that’s exactly how we need to be thinking about each and every position we are in or looking to get in.
Editor, MarketReview.com
John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.
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