All About Shorting (or Not Shorting) Snap, Inc. Stock

Snap (SNAP -0.18%) recently went public, and has grown to unbelievable valuation multiples within the first few trading days. Some investors might be interested in betting against shares either by shorting or with options.

In this clip from Industry Focus: Tech, Motley Fool analyst Dylan Lewis and tech contributor Evan Niu explain why it's a risky bet and difficult to implement within a few days of its IPO. Find out why shorting in general is a bit riskier than most investors would be comfortable with.

A full transcript follows the video.

This podcast was recorded on March 3, 2017.

Dylan Lewis: So, Evan, I maintain my "I'm not touching this stock" position at this point, given the company's strategy that we just talked about and the valuation. Those are two things that are big red flags for me. But I'll also say I'm very generally against buying a super high-growth company in its first few quarters after going public, simply because there is so much volatility in the share price. If you look back at the big tech IPOs from 2016, I think there were three of note: Twilio, Nutanix, and LINE Corp. Twilio IPO-ed at $15, shares popped 90% on the first day, ran up to over $60 a share in September, and has fallen back down to the high $20s since. Nutanix, priced at $16, shares popped 145% on the first day. They currently trade somewhere in the mid-20s. Lastly, LINE Corp priced at $32, shares popped 27% on the first day, currently trade in the mid-30s. What you will see with all of those is huge first-day trading spikes, a lot of enthusiasm, and then a fall back down to a much more moderate valuation. Of those three, only Twilio is above where shares ended on day one, and they're up about 10%. I run through that list just to highlight there's a ton of volatility and a ton of hype that comes into these early tech companies. It's OK to sit on the sidelines. Even if you're a Snapchat bull, it might make sense to hang back a little bit and let the market settle on a little bit more on an agreed-upon price. Let some of those early employees actually sell their shares when the lock-ups expire and have a little bit more supply out there on the market, and you might wind up getting a better price for what you're buying.

Evan Niu: Yeah. Even if you like the company, it doesn't mean you have to like the stock. Right? At these current levels, for sure.

Lewis: Absolutely. And I'll say, I like the platform. I use Snapchat. I have used it for several years. It's a cool way to mess around with my friends. I'm not sold on the business case yet, and I'm certainly not sold on the stock. But, you can like one without liking the other, or liking all three, for that matter.

Niu: Right. It's just a valuation.

Lewis: And when we talk about the valuation struggles, some of the business struggles that we see for the company, we're not the only ones out there. I think there are a lot of people out there who are bearish on Snap. I think the average investor out there sees all that bear sentiment and says, "OK, well, I'm hearing that it's overvalued. To me, that triggers the idea that maybe I should short it, or use some options to make a bearish bet against the company." And I've actually seen some murmurs about this on Twitter, and I think someone might have written in on The Motley Fool podcast group about this. I'm generally against advising anyone to short anything, because the downside can be pretty catastrophic. But I think it's a question we'll see a decent amount around these types of times. Evan, do you want to explain a little bit why investors can't do any shorting right now, and there really isn't much they can do in the ways of options at the moment?

Niu: Technically, you can short a stock early on, shortly after going public. But it's really hard. If you think about who actually got shares -- you have underwriters and investors, institutional and retail. Of course, when you short a stock, you're borrowing the shares to go sell, and then you need to buy them back at a later time, ideally at a lower price to return them. But there's not a lot of people in the early days, in general, of IPOs that are A, willing to lend their shares -- there's just not a lot of supply on the lending side, in terms of securities lending. There's really just not a lot to go around. And, to add on to that, a lot of brokers can set their own internal requirements to mitigate their own risk exposure. For example, I used to work at Charles Schwab (SCHW 1.14%). Schwab is very conservative. They really don't like taking a lot of risk. Most IPOs aren't even marginable for around the first 30 days. You really just can't short them if Schwab doesn't let you have them in the margin account. But that's just Schwab, every broker will have their own requirements. So, it's really hard to short shares directly. And even if you could, like you mentioned before, it's so volatile, so it's just kind of a crapshoot either way. So, it's probably not a really great idea to go short a stock that just went public as soon as you can, just because it's a tricky proposition to begin with. In terms of options, options get issued every so often. The first time that a stock can technically be eligible to have options created for it is about five days after the IPO. It's up to the options exchanges to decide if they want to create these contracts, and the Options Clearing Corporation, if they want to create these contracts based on investor demand.

There's a handful of requirements for a stock to even have options on it. The most important one is the five-day thing. They'll meet all the other requirements pretty easily. I would expect that options on Snap would show up, probably, next week or the week after that. Obviously, there's a lot of interest and demand around this offering, so I imagine that the options Clearing Corporation will probably issue these things out pretty soon. If you want to bet against it -- which, to be totally honest, I'm thinking about doing -- shorting is certainly very risky, and so is options. So, these are both very risky in general. But I think, with options, there are a million strategies you can put together. But I think you could put together a bearish strategy with options in a way that also controls your risk better, versus if you short it straight out, theoretically, you have unlimited downside if the stock keeps running like it does. With options, depending on what strategy you pick, you can pick some that are actually a little bit more conservative in terms of your risk exposure. But yeah, I'll be keeping an eye out for this. I think it will come down pretty soon.

Lewis: Yeah, I think that options discussion might make for a great Industry Focus episode in the future. I think for Fools out there who are seeing what's going on with Snap, you always have to kind of remind yourself that nothing about the core business has changed from the day before it went public to today. All of the key quarterly financials and business metrics that we like to look at are exactly the same as they were before. It's just that market sentiment and hype has pushed the stock up. If you continue to like it at that valuation, then it doesn't really matter, for people that are a little bit more sensitive to high-valuation stocks that might keep you out of it. 

Niu: Yeah. I think the market will sober up pretty quickly.