How to Trade the Bear with Short Seller Jim Chanos

If you haven’t heard about Jim Chanos, you probably should. He’s one of the best-known short traders in the industry, and has an enviable track record of spotting companies who don’t live up to their expectations. He’s known for taking large positions against companies that have something to hide, including against Enron, one of the most spectacular corporate collapses in US corporate history.

Highlighting companies that fail

Fundamental investors look for companies with basic strength, and then invest for the long term. Chanos is the mirror image. He doesn’t look for short-term technical weakness – instead, he looks for companies that have fundamental problems, acting more as a whistleblower than a typical investor who shorts stocks.

Enron is a good example – he conducted a minute investigation of their “mark-to-model “approach, which sets company valuations based on financial models, rather than setting values based on market demand. His clear conclusion was that Enron was using this to overstate earnings, and took an increasingly large short position on the company starting in 2001. While no one could have predicted – or could they? – Enron’s subsequent market deception, his ability to zoom in on things that don’t smell right gave him a unique perspective from which he generated massive profits. It’s also worth noting that Chanos is not a short-term short investor – he believes in taking long-term positions against companies that have fundamental problems.

Chanos on China

Chanos has been a long-time skeptic about China. Back in 2010, he predicted that the Chinese economy would head for a catastrophic crash – not unlike what happened in Dubai, although immeasurably worse. He continues to stand by this prediction, which is supported by recent declines in Chinese economic growth. Given the fact that China is now building complete and largely unpopulated cities in anticipation of predicted growth, it’s difficult to disagree with his view – although many still will. He is particularly concerned about the possibility of a property bubble, specifically outside of the residential sector – seeing a potential overwhelming supply of commercial real estate.

A few words of wisdom on short trading

It’s interesting to see what Chanos said recently about taking short positions – particularly given his track record of success. He’s particularly keen to debunk myths about short trading, saying that it is perfectly possible to manage short-trading risk despite conventional wisdom to the contrary.

While he freely admits there are big risks in short trading, such as squeezes and margin calls, he firmly rejects the idea that short trading creates unlimited risk. Just like any position, a short position can be managed with stop losses and appropriate coverage, making short trading an acceptable approach to the market. He also points out that if you trade as a limited partnership, you can only lose as much as you put in to the partnership.

Chanos also disputes another old chestnut – that short traders cannot make more than a 100% return on their capital. He points out that if you short a stock that then declines by 50%, you may short additional shares without having to come up with any more cash. In other words, it’s perfectly possible to compound returns when you sell short, just like you can if you are trading long.

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