Short selling and “reverse torpedoes” – how they can help a long only asset manager

With so many pockets of swollen short selling catching so many headlines how can a long only fund manager take advantage of this? With the US defense secretary stepping down it seems a good time to use a military phrase that sums up a profitable strategy for this community. “Reverse torpedoes” was a term coined by Deutsche Bank to describe the art of buying shares in companies that are heavily shorted with the aim of capturing a profit when these firms rebound in price. We have zeroed in on research by DB’s quant team to highlight this phenomenon and explain how traditional asset managers can exploit a jump in price that is 1.5 times more likely than chance.

There are a myriad of reasons why short selling has been breaking out, which must be frustrating for fund managers who cannot sell short. Companies likely to be in the cross hairs can be found in the following sectors: Retail, Chinese firms listed overseas, Solar, Semi-conductors and mid tier European banks. These are all areas that we have written about in recent months.

To some, “reverse torpedoes” are a short squeeze by another name. To us, it is a better name since it is more precise. Technically, short squeezes only occur when short sellers are forced to buy back the shares they are short due to recalls. In reality, these are extremely rare events for most mid and large cap securities since the Prime Brokers and Agent Lenders are skilled at preventing them happening. On the other hand, very heavily shorted stocks do often rebound after a big price fall for all manner of reasons, and this is what “reverse torpedoes” encapsulate.

The weight of long only money taking advantage of overly short sold stocks is far from a new way of making money. At the same time it is good to see the data prove that it works statistically. Plus, short selling has been very low since March 09 when central banks began to underpin markets, and thus opportunities for this tactic have been sparse. An end to US quantitative easing, the continued sovereign debt issue and clear evidence that most countries are coming out of recession very slowly have given confidence to the short sellers and this, in turn, could provide an opportunity for the long only funds.