Short Selling Small Caps

I don't often talk about trading small cap stocks, because it doesn't really teach you much about how the bigger, more important markets move.  If you are shorting stocks, you are mostly reacting, not anticipating.  Its almost like a whole different world.  Trading futures and index options is a tough game, but one which I am involved in because of scalability and strategy diversification.  The edges in futures are much smaller than the edges you will find in individual stocks, especially retail driven small cap stocks.  

You have to consider who is on the other side of your trade.  Is it institutions or retail traders?  One has a lot more buying power and is much better informed than the other. If you look at the Stocktwits boards, you would think that the average IQ of a retail trader is in the low 80s.  Most of these daytraders have never read an SEC filing in their life.   Probably the extent of their research is looking at charts, doing some paper napkin analysis. 

You also see many shorting small cap stocks these days, especially the biggest gainers of the day.  Now these are your better educated traders, and a lot of them do fundamental analysis and have a good understanding about the float, dilution, SEC filings, etc.  But their Achilles heel is not ignorance, but arrogance.  Thinking that they can't lose, because they usually win, and refusing to take losses and holding on to a short that is going against them, which is much more dangerous than holding a long that is losing.  When you are getting short squeezed, your margin requirements go up as your account equity goes down, bringing on a margin call that much more quickly than holding a losing long position. 

It used to be less popular and a lesser known strategy back in the day before you had short biased educators like Tim Sykes come along and teach it to a huge pool of newbies.  In the old days when there weren't so many trading "educators" and stock alert services, there weren't that many short sellers in the small cap world. 

Back then, it was safer to short, with very few outlier moves.  There was a smaller pool of traders chasing these stocks and a much smaller pool who could get short squeezed.  So you didn't get the infinite short squeezes like a GME, AMC, etc, because the retail buying power for pump and dumps was just not as big as it is today.  The sheer number of daytraders is so much more now than at anytime in the last 20 years, they can overwhelm low float stocks with their cumulative volume for several days.  It is amazing to see so many ridiculous supernova parabolic moves since spring of 2020.  In this new era, the stock market is a literal minefield for the short seller.  I would only recommend it if you are super disciplined and can take your stop losses and never let losers get out of control.  Easier said than done.  Also, the borrow fees, short interest fees, and occasional buyins, usually at the worst time right before the stock is about to enter a 2 week downtrend. 

Shorting pump and dumps was my main strategy for several years, but I didn't learn that much about trading because it was too "easy".  What I mean by easy is that if you could hang on to your short position, 95+% of the time, the trade would go in your direction, even if you got squeezed for a day or two before it did.  When you win more than 95% of the time, you develop bad habits, you get stubborn and hang on to losers because they almost always turn into winners if you can withstand the storm.  Of course during the rare times when they keep going up, you lose everything you made that year in one day.  Also, you don't learn anything about predicting stock price movement, because the end result of these pump and dumps is essentially a fait accompli. 

Shorting pump and dumps is a winning strategy, in a similar way that selling index puts is a winning strategy.  You are essentially short gamma.  You win most of the time.  But the few times that you lose, they dwarf the size of your wins.   If you can deal with the big losses, and not completely blow up, then its a great way to make money in the markets.  But again, you don't really learn that much from selling index puts or from shorting pump and dumps.  You don't develop any intuition about market direction. 

In the short selling world, there is a fine line between good risk management and being too careful.  If you are too careful, your returns will be low, and it will be bleeding out from repeated stop losses, covering at bad prices.  In that case, you never blow up, but you don't make all that much either.  But what's worse is if you don't manage the right side of the tail distribution, and cut off the outlier moves.  If you don't cut the losses at a certain point, then you are going to be taken out by a black swan move, such as this:  

A stock going from $4 to $100 over 4 trading days back in 2016.  I actually started shorting this in the 20s thinking it was overdone but by pure luck, I couldn't find more borrows, otherwise I would have gone in heavy.  I was able to withstand the storm, although it was quite painful.  I had to reduce my position near the top due to potential margin calls.  If I had short 25% of my acccount balance on DRYS at 20, and never reduced, I would have lost everything at the top at 100.  

There were quite a few blow ups among short sellers on this one.  What is interesting about DRYS is that the CEO George Economou was then able to dilute shareholders continuously on the other side of the peak, as retail bagholders kept averaging down, buying the dip, thinking about how much the stock is down from the peak, dreaming of a repeat of that monster move.  They provided the liquidity for the CEO to raise several hundred million and recapitalize.  He then was able to use his super voting rights to acquire the fully capitalized company after the dust settled.  Essentially all the retail bagholder money went to the CEO via the stock market.   

That shows you how greedy retail investors looking for big gains and looking in the rear view mirror provide the liquidity for these companies to keep selling stock after the pump and as it keeps dumping.  Its actually stock manipulation 101.  The higher a stock goes, the more it entices traders to buy as it goes down from the peak.  Most retail investors think a stock is cheap when it is down a huge amount from a recent peak.  A good recent example of this is CLOV, a Reddit favorite meme stock.  

CLOV just happens to have their SPAC lockup expiration in July, and I'm sure that big pump in June to over $28 has done them a huge favor in giving them willing buyers on the way down.  After seeing it go up to $28 like a bottle rocket just a month ago, retail bagholders have either averaged down, or new ones got lured in at 14,13,12,11,10,9,8 since it seems like such a big discount.  

The SPX is at an all time high, I am surprised, but not shocked.  Nothing shocks me anymore when the SPX is going up.  The buying power and liquidity backing it up is ridiculous.  I still think we are in a range bound market, with the lower bound around 4250, and upper bound around these levels, but I probably sound like an old pit trader complaining about algos when he can't adjust to the new markets.  CTAs heavily long, weak seasonal period for the next 2 months, and retail message board activity in SPY at very high levels are warning signs.