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Commentary on The Capital Markets- Category [Market Musings]

I just saw an utterly amusing "interview" on CNBS with Jim Chanos in which he defended continuing to be short Valeant.

The problem is that his argument doesn't pass the third grade arithmetic test.

Let's start with the basics: When you are short your maximum profit, absent leverage, is 100%.

That is, if you short something at $200 a share (as Chanos did in this case) you can at most make $200/share, and for that to happen the stock has to go to zero.

So let's take Valeant.  He started at $200 and now the price is $35, which he's trying to talk down today.

Fine, except for one problem: He's gotten 82.5% of the maximum possible return out of that trade.

The only way he can make more than the original $200 is if he doubles into the position as it falls, which does allow him to make more but a price-recovery now takes that leverage and turns it into an ever-escalating loser!  It is very, very easy when doubling into a falling stock on the short side to lose vastly more than you originally could have profited.

Let's say you short a stock 100 shares of stock @ $100.  It falls to $50, which frees half your margin.  You add to the short and now are short 200 shares, but your blended "cost" is $75, not $100.  It then falls to $25 and you are ecstatic!  What do you do?

If the answer is "short more" you're asking to get your ass reamed; if the price just goes back to $50, which is well under your original short price, you are now underwater and instead of a big profit you have a big loss.  In fact if you went to the wall with that position you're going to get a margin call and not only will you have a big loss on paper you'll have a big crystallized -- that is real and due now cash loss.

You can have all the conviction you want but the fact of the matter is that whenever you have managed to get 82% of the maximum return possible out of a trade you are a damned idiot if you don't take the money.

I don't care how good you are; nobody is always right and when you're using leverage to double into positions, especially on the short side, it only takes one or two mistakes to blow you to bits.

Chanos has a good record, but he's gotten arrogant.  There's no logical or mathematical defense for making a bet on the short side, having it be right, getting 80% of the possible return out of the trade and remaining in it.  There's a clean argument when you're up 20 or 30% on a short to stay with it but not when you've gotten better than 80% of the maximum possible return on your trade.  No matter how convicted you are if you have that sort of gain on a short you take it.

To those who are following him in shorting Valeant here remember that your basis on a short is not $200, it's $34 and change.  If the price doubles he still has a profit, assuming he hasn't levered into the position but your account will be blown up.

CNBS, of course, never mentions this tiny little detail or asks people like Chanos to justify their continued position and table-pounding on that basis.

Gee, I wonder why?

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