Acquisition risk in a short position

By: ispeculatornew
Date posted: 08.25.2010 (4:00 am) | Write a Comment  (5 Comments)

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Going short is always a risky proposition as is going long of course. Yes, in theory, a stock can go to one million and you could be wiped out but in reality, like any other price movement, it will usually happen very gradually and you will be able to adjust. There is one big difference though  and that is the extreme rise that can occur when a company bids for a stock that you have shorted.

Last week was a good reminder of what can happen when BHP Billiton made a hostile offer to buy giant Canadian company Potash for $38 billion, which was well abode Potash’s market value. The worst part for short investors in Potash is that the stock shot up much higher than the 130$ per share that was offered on speculation that it was the first offer by BHP but that there will be at least another one. The result? Potash ended Tuesday over 143$, much much higher than Monday’s $112.15 close, almost 30% higher.  Just take a look at the chart of Potash and you will get a better idea of what happened.

Another example

On Thursday, Intel (INTC) announced it was acquiring software security company McAfee (MFE) for $7.68 Billion, a premium of over 60% from the previous close. That means that short investors in McAfee lost a huge amount on that trade. Having a stop loss is useful and necessary but in cases like this, it offers little protection as the stock moves past the stop loss.

To be honest, the threat is important right now because many companies are sitting on huge cash piles which they often want to use in acquisitions.

How to avoid such situations…

There are no ways to make sure that shorting an acquired company will not happen of course but avoiding companies that are speculated to be for sale is one way to do it. In the case of Potash, I don’t think anyone saw this coming and it would have been difficult. But in the case of McAfee, it was easier to see that possibility given its industry and how powerful players could easily move into software security. Companies like Microsoft (MSFT) had been rumored to look into such acquisitions in the past.

Personally, I have not had the impression that many of the companies that I short are good potential targets. Last year, I was worried that Yahoo would be a good target and that was certainly a major worry when I would short the stock. But after its search deal with Microsoft, it seemed very unlikely and I have not had to worry about it since.

Other Risk to consider…short squeeze

When traders notice a very high concentration of short positions on a stock, they can start to drive up the stock which will cause the short traders to be “forced out” of their positions. Of course, those getting out will be doing so at a higher price, which can create even more short positions to reach their “stop loss” limits. You can imagine the effect it can have on a stock when this cycle begins. Then, once the cycle is advanced, the person who started the cycle can close out his position with a nice profit.

Such a strategy is not executed often because a lot of money is required to move a stock enough to create a short squeeze. To be honest, I do not (yet) consider this possibility when selecting short stock picks at the moment but maybe one day I will get burned and have to look into it.

Still a good idea to go short?

I’ve said it many times, I think the long & short trading model that I’m using is perfect for the type of speculative trading that I am doing. It does have some risk involved but as long as the potential gains are large enough, I’m fine with it. That being said, I think that all traders that use short positions had second thoughts this week seeing how Potash and McAfee took huge leaps….

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  1. Comment by Zavi — August 25, 2010 @ 7:14 am

    Yes, huge leaps!! To be followed closely!

    I’ve heard before about take over and merger arbitrage. If you can trade based on these events, you can gain a lot but there are of course some risks. But this strategy is a little bit too difficult to predict and to evaluate for me.

  2. Comment by IS — August 26, 2010 @ 8:22 am

    @Zavi – I would say that that type of trading is fairly complex and probably not something you would do part time:)

  3. Comment by Erlik — August 27, 2010 @ 7:26 am

    Would it not be better to purchase a put option rather than shorting the stock? That way your loss is limited to the price you paid for your option.

  4. […] of over 200% in a couple of weeks. And if anyone was short 3Par? Well as we discussed last week, shorting a stock that is an acquisition target can be costly, especially when the stock goes up so much. Luckily, on such a small stock, there were probably […]

  5. Comment by IS — August 30, 2010 @ 4:32 am

    @Erlik – They are both very different. In a long & short trading, you would make money even if the stock went up, as long as the stock that you are long goes up more, it’s all about relative.

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