Help me leverage my ability to pick failing companies.

June 4, 2007 9:52 AM

Help me leverage my ability to pick failing companies.

I've been playing fantasy stock market games lately, and have been doing pretty well at it (325% returns in two and a half months). Out of fifty picks, I've made money on 80% of my long positions and 93% of my short positions. By FAR my biggest gains have been on short positions (multiple instances of +70% returns in under two weeks). I have a few thousand in a brokerage account on ETrade that I use for short-term high-risk experiments with real money, but brokerage restrictions involving short positions prevent me from mirroring my fantasy gains in real life.

I seem to be extremely good at picking out when a company is about to implode, just before it does so. There's a new forthcoming implosion on my radar today. How can a market dabbler like myself effectively leverage this ability to consistently spot good shorts, given brokerage restrictions on shorting stocks?

posted by Ryvar to work & money (13 comments total)

What are the regulations exactly? The uptick rule or are you betting on recent IPOs? Or do they want you to have more money in your account to deduct if the short goes the wrong direction?
posted by geoff. at 10:15 AM on June 4, 2007

If options are available, buy out-of-the-money puts. Using funds you can afford to lose.
posted by drdanger at 10:26 AM on June 4, 2007

geoff - I think the SEC abolished the uptick rule
posted by taliaferro at 10:28 AM on June 4, 2007

Options are a reasonable alternative. If you think the stock price will drop you could (a) buy puts, and/or (b) write calls.

Your broker may have some restrictions on options trading. Usually you have to prove that you are grown up who knows what they are doing and has money to lose.
posted by GarageWine at 10:30 AM on June 4, 2007

The thing about options that isn't adequately reflected in the fantasy games is that not only do you have to know which stock is going down, you have to make a bet on when it's going to happen. If you're wrong and the stock doesn't go down until the day after options expiration, you lose your bet. In other words, as someone said, time is on your side with a long position, but time is against you when you short.

Large players in the market manipulate the stock prices on options day; if they can get a price to close within a certain range of a certain price, their options will close out of the money and not be exercised. A day trader whose site I read won't even trade on options expirations days because the market incentives are so artificial on those days.

I too play these fantasy games from time to time, and I'm like you - most of my major outperformance comes from my "down" picks. But I would never screw around with options with my own money, not even a covered short. That is someone else's game and I am not equipped to play it with the big boys. I stick to long positions.
posted by ikkyu2 at 11:19 AM on June 4, 2007

Well if you're going to trade in options, definitely get Volatility surface and John Hull's book on derivatives that is pretty much the standard. It definitely has flaws, but is a necessary primer.

As a rule, fantasy stock picks are sort of like coaching a football team is to picking plays in Madden. The basics are all there, but you can definitely go for it on fourth down or constantly run on the extra point way more than you can in reality.
posted by geoff. at 11:30 AM on June 4, 2007

Geoff: believe me, I learned that lesson on my very first real-money pick: on April 4th, Western Refining (WNR) was at 39 and looking to be on a longterm upward trend. The next day the FTC announced their intent to block the merger with Giant Industries (GI), and the stock promptly plunged to 36. I got out at 36.8, it bottomed out at 36.2 and then started rallying. At 37.25 I cashed back in twice my intial investment and rode it back up to 39.

Today, two months later, it's at 52.83.

There's nothing in that ETrade account I can't afford to lose, but I'm very glad, in retrospect, for that introductory lesson.

My only problem now is that I've almost never miscalled a short (the one I did was a 10% loss) and I'm finding it impossible to leverage this with ETrade.
posted by Ryvar at 12:39 PM on June 4, 2007

btw - id be willing to bet that the traffic on these fantasy games is helping someone pick stocks.
posted by nihlton at 2:36 PM on June 4, 2007

While not a true fantasy game, I find that the top-tier players on Motley Fool's CAPS game, taken with a grain of salt, dole out some AMAZINGLY good (and timely!) tips on stocks you might want to look at. Not that it should govern your investments (at all), but as a flagging-interesting-companies system it's tops.

With 30,000 players, you also can develop a good sense for what small investors as a demographic think about a given stock - useful for knowledge for the small investor trying to beat out all the other small investors.
posted by Ryvar at 2:53 PM on June 4, 2007

I know, Ryvar - I'm one of them. :)

There are a lot of problems with CAPS underperform picks. One of them is that you suffer no extra penalty if your pick doesn't come true by a scheduled time. If you know a stock is looking for a fall, you can just wait and wait and wait until it finally happens.

There is no real life way to go short on a stock that replicates this feature. Mr Market can stay irrational longer than you can stay solvent. In other words, my shorts account for nearly all the outperformance of my CAPS portfolio, but if I'd bought them with one or two months lead time as is normal for a short, I'd've been out of the money in the majority of cases. It's also hard to find someone to cover your short on these small cap stocks - often you wind up paying a premium for that option which wipes out a lot of the percentage profit behind it.

Another problem is that the broad market has been behaving fairly unusually since CAPS got started last summer - it's been doing nothing but go up. A lot of folks aren't convinced that this is the new way the markets are now; at some point we might even return to a situation where the market goes down now and then. I don't mean to deflate your enthusiasm but I would be wary about extending your CAPS expertise to real life.
posted by ikkyu2 at 4:49 PM on June 4, 2007

Re: Options. In addition to the time-limit problem mentioned by ikkyu2, it's my understanding that option prices are not set by the market, they are set by professionals using complex forecasting software. This gives them the edge, and means that you and I are not playing on a level field.
posted by exphysicist345 at 8:46 PM on June 4, 2007

exphysicist, I'm not sure I'd agree with that. Futures (options) are traded on a market, the Chicago Mercantile Exchange. Serious traders on that market use extremely sophisticated software, often crewed by a batch of Ph.D.s in statistics and computer science, to help them make their trading decisions.

But exactly the same thing is true of the NYSE, AMEX, and Nasdaq. So this is certainly not a valid reason to prefer the latter over the former.
posted by ikkyu2 at 9:04 PM on June 4, 2007

ikkyu2: No worries on that front. I wouldn't consider CAPS a good investment modelling tool any more than I would consider Wikipedia an authoritative source of information.

Both have exceptional utility in providing you tons of items of interest for followup, but you shouldn't rely on either remotely (Wikipedia because of who is authoring it, and CAPS because it abjectly fails at reflecting the reality of investing).

I don't, in short, use CAPS as my sandbox. Sorry if I gave the wrong impression :)

Oh and as for the market of late - I agree. I've been concerned that my ability to select shorts is somehow an indirect result of this, and am frankly more than a little worried about what will happen if and when reality catches up with the market.
posted by Ryvar at 9:08 PM on June 4, 2007