Uber is high, besides being bigger. With its current $62 billion valuation, people are wondering how to profit if things go the other way for Uber.
In fact author, journalist, instructor, jack of all trades, and not master of finance, Quartz’s Steve Levine recently declared:
Investors have placed a one-way bet on Uber—which made us want to find a way to short it
After an epic post, Mr. Levine finally concludes shorting Uber is impossible. Along the way he consults many academics, but doesn’t bother interviewing famous Enron short-seller, Jim Chanos of Kynikos.
Yes, Mr. Levine you can not short Uber or other unicorns, but why bother? If you are interested in making money, why not just short San Francisco.
According to Mr. Levine , you need the following for the successful short trade:
We start with the two simple rules governing the successful short: You need superior information, and a high trading volume so you can sell your position fast.
This is not exactly true. First, you need “superior information” for any trade, long or short. Secondly, you don’t need to sell in high trading volume to be successful. To profit from the short trade you need to sell the stock at a high price and then buy back the stock at a lower price.
To sell first, you first need stock to sell. Normally in the public markets, the short-seller first borrows the stock that is then sold at the high price. When the stock price drops, then the short-seller buys back and then returns the stock to the lender.
It’s really the mechanics of the short trade, which makes shorting Uber or unicorn nearly impossible. To execute the trade you first need someone to lend you the shares and secondly you need a liquid market to sell and then buy back the stock.
Startups and later stage companies occupy the world of private equity, which means not public markets. In private markets there is not much liquidity nor information. It for these reasons that private equity is favored by larger players, such as the Yale Endowment.
Shorting Uber is nearly impossible, because you first need actual Uber shares to sell. Uber and other unicorns make it hard for anyone to sell their shares, let alone lend them to someone else. So shorting actual Uber stock is nearly impossible, based upon the short trade itself.
After much rambling, Mr. Levine then decides:
I decided to look at CDS as a possible path to shorting Uber.
CDS stands for Credit Default Swap. Credit default swaps works similar to car insurance. One person pays a premium to another party. In exchange, the other party agrees to give you the full value of your car when damaged.
Instead of damaged cars, the credit default swaps are insurance on bad debt. If a bonds defaults, then you will receive the full principal amount of the bond. Credit default swaps are not even a direct short. Instead, the CDS was used as a bet on a company’s improving or decreasing credit risk.
If you really want to short Uber debt, you would use a total return swap. Why? Because derivatives are an alternative to shorting the actual security such as stock or bonds. Derivatives are just financial contracts where two parties exchange promises, like the futures contract.
In a futures contract, one party promises to deliver goods at future date and the other party promises to pay an agreed upon price. Farmers commonly use futures contracts to lock in the price for their harvests. The time between planting and harvest is long and prices can change. Farmers can shift the price risk to someone else, the speculator. Here the farmer is short and the speculator would be long.
In the spring, the farmer would sell futures contract that guarantee the price of the harvest. The contracts sold call for the delivery of corn on a date in the fall. On that future date, the speculator will pay the agreed upon price of $100 per bushel. If the price of corn declines, then the farmers wins. The speculator hopes the price will be higher, because after receiving the corn, the speculator can sell the corn for more than $100 per bushel.
Equity Index Futures
In 1970’s, there began many new futures contracts, not for physical assets, but financial ones, such as stocks. Instead of delivering corn, the seller of the futures contract agrees to deliver a basket of stocks. The speculator still agrees to pay an agreed upon price.
Futures contracts on baskets of stock are called equity index futures. They have the advantage of allowing an investor to short a basket of stocks. If you think the S & P 500 Index will decrease, you would sell an equity index future. But instead of delivering the actual stock, you can deliver the cash value of the stock basket.
Assume, you think the S & P 500 index is too high at 2200. You decide to short the index by selling one futures contract (E-mini). The contract you sell will expire in February 2017. At that time, the buyer of the contract has agreed to pay you the current value of the index, or $110,000.
In February 2017, the S & P 500 Index does decline and the cash value of the stock you must deliver is $75,000. Instead of delivering the basket of stock, you pay $75,000 and the other party pays you $110,000. The net amount of $35,000 is your profit from shorting the S & P 500 Index.
Real Estate Futures
Mr. Levine concludes he can’t short Uber, but along the way, he stumbles upon this potential trade:
You also might create a derivative that shorts the San Francisco real estate market, which in the past has boomed during big IPOs.
Someone did “create” such a derivative and it was done in part by Nobel Prize winner, Robert Shiller. In 2007 futures contracts started trading at the CME allowing anyone to be either long or short real estate, or this case San Francisco.
The futures contracts are based upon the Case-Shiller Home Price Index. Futures buyers and sellers are betting solely on the dollar value of an index. The index is the price level residential real estate. For San Francisco, the index measures the prices of single family residential homes in the counties of Alameda, Contra, Marin, San Mateo, and San Francisco.
In the graph below shows the beginning of the index in 2006 at the level of 217.52. As the economy imploded in 2008, the index reached a low of 117.17. At May 2016, the index level was 227.54. Each futures contract is worth $250 times the index level. So for May 2016, the San Francisco Real Estate contract is worth $56,885.
If you want to short San Francisco, you would sell one futures contract for $56,885. Let us assume, the contract will expire in December 2017. Between then and now, the bubble bursts, money stops flowing into San Francisco, and people decide to leave, pushing down home prices.
In December 2017, the index level is no longer 217.52, but closer to 117.17 as in 2008. Now the value of the contract is $29,293. On expiration date of the contract, you would deliver the dollar value of the index or $29,293 and be paid the agreed upon amount of $56,885. The profit from shorting San Francisco is $27,592.
This post is for educational purposes only and should not be used for investment purposes. Short-selling should only done by experts and certainly not by journalists or in their ramblings.