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If you’ve been in the market for some time, chances are good you’ve heard of short seller reports.

I’m talking about those few Twitter guys, whose one tweet may send shares running scared for their lives…

Case in point, Camber Energy (CEI), earlier today:

One of the most active stocks of the past few sessions went from nearly $3 to barely over $1 in under 30 minutes, following a bearish report by Kerrisdale Capital.

So, what is going on here and how can one tweet drop shares a full 70%? Let me explain…

Who Are Activist Short Sellers?

The answer is pretty self-explanatory: these are short traders who develop deep bearish convictions based on extensive research into the company – which they don’t hesitate to communicate to the rest of us, usually by means of Twitter.

Obviously, it’s no simple task – short-sellers that can truly crash a stock have long and well-established track records of uncovering things that the market has been missing.

More often than not, these guys use unconventional, “private investigator-type” methods to uncover fraud, hence, if the allegations look credible enough, a stock may react in the most violent of ways – after all, who wants to own a company that’s misleading the public?

Due to the investigative nature of their work, their report reports often look and sound more like an Agatha Christie crime novel, or a detective TV show, rather than a conventional analyst report.

Here’s an excerpt from Hindenburg Research’s report on HMBL:

The analyst uses all kinds of public data to find that HMBL’s $15M partner company is a hoax.

But no matter the language, the styling, or the manners – when these guys speak, it’s worth listening. And I don’t mean to jump short or sell your long immediately, but listen – they may make some very good points.

Andrew Left, for one, better known as Citron Research on Twitter has had some major hits in the past – like Valeant Pharmaceuticals in 2015 and even the whole Evergrande thing, which he spoke about as early as 2012.

Obviously, not every report is going to make it, but I’d strongly recommend you are aware and following when they tweet.

Here are a few of the guys I personally think are worth following:

  • Citron Research
  • Hindenburg Research
  • Muddy Waters Research
  • Spruce Point Capital

Why Should You Care?

There are a host of reasons.

First, these guys DO have some truly interesting research and ways of analyzing stocks you may have never thought of – from a purely educational standpoint their reports are worth a read, especially since they don’t come out very often.

Second, they can have a notable impact even on large-cap names.

Third, they may easily, single-handedly destroy small-cap stocks – remember the CEI example I mentioned at the beginning of this article?

And it’s the third one that I want to focus on.

As momentum traders, we trade intraday action in a particular stock – we don’t really care about the underlying company.

And the truth of the matter, with small-cap runners, oftentimes the underlying company’s fundamentals and storyline are… less than solid, let’s stick to diplomatic terms!

When such a stock has a multiday or a multiweek run, it may easily become a target of activist short-sellers – and you’ve already seen what they can do to its shares.

If you’re actively trading stocks with shady backgrounds – this is definitely one huge risk factor you should keep in mind, especially when doing so at elevated price levels, days and weeks into the move.

How Can You Trade It?

Short reports are not black and white – nothing in the market is.

I would never put on a huge short position or offload all of my long shares, simply because I get a tweet notification from one of these guys.

What I generally care about is how the price reacts to the report. There are plenty of ways to trade them, but with my style, I like to focus on 2 setups:

  • A Short Trap and a Squeeze

You may see a famed short seller speak about an ongoing runner, with menial reaction from the stock price. This is exactly what gets me interested – I know there are traders who will get short, following a short report. If the price doesn’t go their way, they’ll be trapped and will have to cover – this may present a great long opportunity.

One good example of that is GameStop (GME) and Citron Research. Here’s what he tweeted right as the stock was hovering around $40:

Well, we all know how this one ended…

If a short seller is bringing in new short traders, yet the stock isn’t going down – watch out for a squeeze and long opportunities.

  • A Bounce Following a Major Selloff

Let’s go back to CEI again. The market clearly took the allegations seriously, given how much the stock has lost and how quickly.

But the flip side here is – such emotional reactionary moves may often be “too much and too quickly”, creating great bounce opportunities.

In today’s example, the stock lost nearly 70% of its value in less than an hour on HUGE volume.

Such an oversell will likely have at least a temporary bounce, as shorts cover and long start buying the dip.

Following dramatic selloffs, it may be worth looking for support areas, places where “a stock stops going down” – around $1.05 in CEI’s case – and making intraday bounce trades against these levels.

Author: Jason Bond

Typically, when I’m looking for oversold stocks to buy I get excited when I find a stock that has fallen 30%, 40%, or even 50% in just a few weeks.

I’ve found that such weakness often precedes one of my favorite setups, the “j-hook” pattern.

Occasionally, however, I come across a stock that has become oversold after a more prolonged sell-off that has lasted several months.

I call these stocks “bleeders.”

Although I prefer to buy oversold stocks that have witnessed a faster sell-off if I find a “bleeder” that is a quality company I become equally as interested.

There’s one such company on my Weekly Watchlist that I really like, and I am about to show you some of the reasons why.

Short-Term trading opportunities always exist in times of uncertainty

One of the most widely respected Wall Street adages says, “Markets hate uncertainty.”

It’s respected, because it is true, especially when it comes to topics such as government policy.

While there is no shortage of historic examples where leaders of democratic nations have made poor decisions that have crippled certain industries, there’s also no shortage of examples where such decisions have eventually been reversed through the democratic process.

When it comes to policy uncertainty in communist nations like China, however, we’re talking about a whole different ball game.

Chinese ADRs face ongoing uncertainty

Chinese ADRs have been operating under the specter of potential, yet unspecified, future fines and the Holding Foreign Companies Accountable Act, which is a 2020 law that requires companies publicly listed on stock exchanges in the US to declare they are not owned or controlled by any foreign government.

Teachable moment: ADRs are American Depositary Receipts, which are shares in foreign corporations that trade as stocks on US exchanges.

But it’s not just the ADR structure that is under attack by US officials, VIEs (variable interest entities) are also in Beijing’s crosshairs.

The VIE is the legal structure that permits Chinese firms incorporated offshore to circumvent Chinese foreign ownership rules, forex restrictions, and tax codes.

Without the VIE structure, Chinese ADRs would not be possible.

And because Chinese ADRs rely on the VIE structure, these securities could lose all their value if Chinese regulators determine the structure is illegal.

Similar to what a number of unscrupulous US companies do, many Chinese companies use complex strategies to circumvent rules and tax laws.  

VIEs were developed just for this purpose, to allow Chinese companies to avoid the foreign ownership restrictions, currency controls, and tax laws that the Chinese government imposes on its companies.

Essentially, VIEs provide a structure for offshore entities to own as much as 100% of an onshore Chinese entity’s profits through a set of licensing and service contracts.

If you think this loophole is something new, think again.

The Chinese government has been aware of its existence for years.

IQIYI Inc. shares are being accumulated as the downtrend slows

While this uncertainty can continue to weigh on many of the Chinese companies until this issue is resolved, we can’t ignore these stocks altogether, since many will continue to offer excellent trading opportunities as this saga continues to play out.

IQIYI Inc. (Ticker: IQ) is a stock that I have been watching since introducing it to readers via my Weekly Watchlist on 09/27.

Based in Haidian, China., IQIYIInc. provides online entertainment service. The company offers movies, television shows, variety shows, and other video content.

Technically, as the chart below uncovers, IQ shares fell to new all-time lows this past week.

Figure 1

At the same time, though, momentum, as measured by the default 14-Day RSI indicator, and two key measures of net volume activity, On-Balance-Volume (OBV) and Accumulation-Distribution, did not make lower lows.

It’s a secondary indicator action like this that often warns when a downtrend is nearing its end.

Once a trader has identified positive divergences such as these, he or she can take a position in one of the following two ways:

  1. Start to slowly build a long position before the trend turns
  2. Wait for the stock to signal that the trend has turned by rising above an area of technical significance

In the case of IQ, as I’ve annotated on the chart above, that level is $8.80/$8.72, where the post-09/07 Anchored VWAP and the most recent pivot high (the 09/22 pivot high) have formed an important resistance confluence.

With 18% of the float currently shorted according to Finviz, this is the key technical area above which I think these shorts will start to be motivated to start covering some of their positions.

Author: Jason Bond

As this past week’s action was getting started, it became apparent that the S&P 500 ETF (SPY) had an initial focus of following through on the prior week’s rebound, to fill the gap up to the 200-hour moving average at 444.50, which is ultimately where the bulls lost their mojo.

Hourly moving averages, specifically the 200-, 30-, and 13-hour moving averages, are key levels I monitor in my daily Total Alpha updates, so to see the SPY subsequently weaken below the 30- and 13-hour moving averages was the early indication that the market was in for a rough week.

The combination of technical weakness, such as I just described, and both economic and political risk, such as the early-week threat of a government shutdown and the ongoing spike in inflationary pressures, is the kind of evidence that should inspire active, nimble traders to consider deviating from their usual bullish postures by acquiring positions that would allow them to benefit from a short-term period of market weakness.

For some of our readers who may still be learning the basics of options trading, and for whom the buying of S&P 500 ETF (SPY) puts or some other bearish options strategy may not be within their comfort zone just yet, there are ETFs that can be purchased which allow traders to profit from downside movement in the S&P 500.

These ETFs are known as inverse ETFs, and today I’m going to walk you through how these ETFs work, the risks associated with them, and how they could have been used to either profit from or help hedge against this week’s selling

 

ETFs, inverse ETFs, and leveraged ETFs. What are they and how do they work?

Before we can get into a discussion about both leveraged and inverse ETFs, it’s important that you at least have a basic understanding of what an ETF is.

ETFs (Exchange-Traded Funds) are open-ended investment funds listed and traded on stock exchanges. 

The term open-ended simply means the fund’s management can issue and redeem shares at any time. 

An ETF’s goal is to replicate, 1-to-1, the performance of an underlying index or basket of assets. 

What are leveraged ETFs?

Leveraged ETFs allow investors to leverage their investment directly without the need to deposit a margin or borrow stocks respectively.

For example, a 1% increase in the performance of an index can result in an approximate 2% (for 2x leveraged ETFs) or 3% (for 3x leveraged ETFs). 

Unfortunately, and this is where many new traders get burned, a downturn in an index’s performance will result in an amplified decline in the returns of the leveraged ETFs.

Now, this next part is very important!

Leveraged ETFs are suitable for investors who have a high conviction in a particular market sector, with a short-term time horizon. We’ll discuss why a little later.

What are inverse ETFs?

Inverse ETFs track the movement of their indices’ performances in the opposite direction. 

In other words, they are designed to have a negative relationship with their benchmark indices. 

Therefore, Inverse ETFs are suitable for investors who are having a bearish view on a market sector and are intending to profit from such a scenario.

Leveraged and inverse ETFs are not designed for investors to buy and hold for the long term. They are meant for active trading purposes.

Many inverse ETFs utilize daily futures contracts and other derivatives to produce their returns. 

There is a negative effect caused by these derivatives, however, in that they require constant rebalancing by the fund manager, which often leads to a deviation from the original investment objectives over time.

These are short-term trading and hedging vehicles that are not meant to be held for more than a day or two.

When to use leveraged and inverse ETFs

A trader with high conviction about a particular market sector or upcoming economic or geopolitical event can buy into these ETFs to gain bearish exposure and earn a higher return than their traditional index-tracking ETFs counterparts.

Investors who are bearish about a market sector can buy into inverse ETFs instead of borrowing securities to short sell, allowing them to avoid the higher costs that come with borrowing shares and obtaining margin during the short-selling process.

A trader would also use these ETFs as hedging tools to protect against losses for an investor’s portfolio holdings, in the event he or she anticipates a short-term, but meaningful pullback in a certain sector.

Here’s how an inverse ETF could have been applied this past week

Listed below are 3 of the most popular inverse S&P 500 ETFs.

First, the ProShares Short S&P 500 (SH) is the most popular inverse ETF, with nearly $3 billion in assets, designed to return -1x the daily return of the S&P 500 Index. For example, a $1 drop in the S&P 500 would cause this ETF to increase by about $1.

If a trader had mild/average that the stock market would start to experience a bearish rotation after struggling to overtake the 200-hour moving average at the start of this past week, this is the instrument that would have been best suited to his or her needs. 

Next, the ProShares UltraShort S&P 500 gives traders looking for a little more volatility a way to add bearish leverage. Specifically, the ETF is a leveraged inverse ETF providing -2x daily returns of the S&P 500. For example, a $1 drop in the S&P 500, would cause this ETF to increase by about $2.

For a trader with higher than average conviction that the stock market would struggle after Monday’s failed to push above the 200-hour moving average, this is the instrument that would have been best suited to his or her needs. 

Lastly, the ProShares UltraPro Short S&P500 gives traders a tool to gain max bearish exposure, with -3x returns. Specifically, the ETF is a leveraged inverse ETF providing -2x daily returns of the S&P 500. For example, a $1 drop in the S&P 500, would cause this ETF to increase by about $3.

Needless to say, this final ETF is the instrument that a trader could have used to short the market earlier this past week if he or she had the extreme conviction that the market would fall.

Tactically, the trading plan would have looked something like this:

  1. Identify your outlook
  2. Identify your conviction level
  3. Identify your target
  4. Identify your risk 
  5. Identity your timeframe

Let’s face it, in this scenario, we have the benefit of hindsight, right?

But we can still use this past week’s events as an example of how these specialized instruments could have been used, with an emphasis on the time frame aspect of the trade.

For this example, let’s just say that the trader’s conviction level that the S&P 500 would turn lower after Monday’s hesitant start was mild/average.

With numbers 1 and 2 on the trading plan list above now satisfied, the trader would move on to setting a target. 

As Figure 1 shows, the 438.40 was thick with support in the form of the 09/22 – 09/23 gap and post-09/20 anchored VWAP.

 

Figure 1

When we’re dealing with the short-term holding times that these inverse ETFs demand in order to work optimally, this also would have been an appropriate target zone for an initial decline, given that SPY’s ATR (Average True Range) at Monday’s high was $5. (Monday’s high of 444.00 – 5 (ATR) = 439.00)

Yes, the market did collapse below the initial 438.40 support level during this past Tuesday’s decline; however, at the time this trade was being set up on Monday, there was no way of predicting such a swoon would occur in such a short period of time.

Now that numbers 1 – 3 on the trading plan list have been established, number 4 (risk) needs to be established.

Given that our discussion began with the S&P 500’s early-week struggle to overtake the 200-hour moving average, this average would have been an appropriate stop-out level, preferably on a closing basis.

Interestingly, as Figure 1 also shows, the area where the 200-hour moving average began the week also housed the Anchored VWAP of the S&P 500’s entire decline from its all-time high on 09/02. 

Such a powerful confluence of resistance helps fortify this level as a stop-out level.

Finally, we come to number 5, the timeframe of the trade.

Remember, inverse and leveraged ETFs are constructed in such a manner that they are only to be used for short-term trades. 

Therefore, if the weakness that was anticipated for this trade did not begin to materialize within 48 hours, the trading plan would have called for the inverse ETF position to be closed out. 

 

Author: Jason Bond