A Thought Exercise For Outsourcing Liquidity Risk

A portfolio manager shorting a stock will size a position not just based on price target and conviction but based on the risk relative to bankroll and relative to the liquidity. There are conventional ways to do this. Volume, days-to-cover, variance, 90s nostalgia factor (kidding on that one…worrying about that going forward is like closing the barn door after the horse escaped). While these inputs inform a sizing decision, the bottleneck in the risk management process is not in the sizing. It’s in the remedy when your sizing turns out to be wrong. Eventually it will be. Your plan needs to tolerate that eventuality.

Most plans are to cut risk by buying back some percentage of your shorts. This is like trading with a stop. You are constructing an option since you cover as the stock goes against you and you add as the stock goes in your favor (remember if you short a stock and it falls, to maintain exposure as a percentage of AUM you need to short even more).

The problem with this plan is it is soft optionality. It’s not the same as buying a hard option like a deep ITM put, or buying an OTM call to hedge your short position. Hard options protect you from gap risk. You know, that thing that happens when a stock is halted. Or when the US goes to sleep. Or when a gamma squeeze creates a massive imbalance.

To improve risk management, managers should at least entertain the question: “if I wanted to buy X amount of deep ITM puts instead of shorting shares how much would it cost?”

The answer to that question comes from market-makers who sit in the middle of the marketplace. They hoover up market intel to synthesize a price so you can know exactly how much it costs to express your view with a hard option. Sure, that price embeds a consultation fee in the form of a vig, but at least they are on the hook for mispricing. Not you.

A market maker’s job is to price the spread between soft optionality and hard optionality by gauging the liquidity required to dynamically hedge. Market makers are also in highly competitive, low margin businesses. If you pass on their price for the hard optionality you must ask yourself…”is my assessment of the liquidity/gap risk that much better than theirs OR are their margins excessive?”

At the very least, you can consider this reasoning a sanity check before you size up a big short.

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