The recent declines in the stock market are making investors nervous. When small investors are seeing big, "safe" companies like AIG and Lehman Brothers go into the tank, they finally start asking questions.
It is one thing when a stock goes down because the management hasn't performed. It deserves to be punished. Lack of confidence in future returns is a very good reason to sell stock. Once an investor has gotten a maximum return on a stock, it's time to sell and look for the next rising star.
Short selling is a way for an investor to make money on a stock when the stock's price goes down. Short selling begins when a the stock is borrowed from the owner of the stock for a fee. Then the stock is sold to the market on an uptick. By selling the stock as the market goes up, this means there are some buyers of the stock who think the price will continue to go up. After the price of the stock drops, the stock short seller buys the stock back at the reduced price, and returns it to the rightful owner.
The naked short seller doesn't even bother acquiring the stock first. Orders are entered with the hope that stock will be available later, at a lower price.
Short selling of stock can go badly quickly. For instance, if a stock price rises, instead of falling, the short seller needs to buy stock at market prices to give back stock to the investor he borrowed it from. He is "covering his shorts" at the higher price and at a net loss. This can cause a fast rise in prices, on top of an already large increase in the price of the stock. A smart short seller ought to buy out-of-money calls to hedge for this possibility.
No one feels sorry for someone exposed to that much risk. Small investors are delighted by this extra bounce in the price, even if it had nothing to do with the company's performance.
When the price goes down, the short seller is licking his chops. All he has to do is to wait for the market to bottom out, before buying the stock at a discount. He buys not to take a stake in a company, but to return the "borrowed" stock to the sad owner, who still owns the depreciated stock. But the stock owner should have bought puts to hedge the drop in price, if he didn't want to own the stock. However, he's unable to unwind the stock, until the short seller gives back his stock. The reason why the stock owner gets involved in this deal is the short term fees he gets when loaning out the stock that he had no intention of selling.
Short selling is blamed for some of the extra market depression. When a lot of short selling takes place in a stock, investors take it as a sign that there is something fundamentally wrong with the company. A stock price is supposed to fairly represent all that is known and unknown about future value of a company.
A large short position indicates price of the stock will soon fall further. This is self-fulfilling prophecy. It can destroy a business. Part of a business's resources is its own treasury stock. A business can raise money quickly by selling shares of itself at market prices. It does this when short term investment opportunies come up, without having to take out a loan or issue a bond. But if its price has been deflated through price manipulation in a tight credit market, the company can go bankrupt, fast. A competitor could use the mechanism of a short sell to put its rival out of business.
Those calling for increased scrutiny of short selling, such as Mad Money's Jim Cramer, believe that the Securities Exchange Commission hasn't been doing its job to enforce the rules around short selling. Two rules that have to be followed are:
Ownership of a stock is pretty easy to check. But if the buying and selling of shorted stocks occur within the same day, it may be too fast for verification. But with fast computers and paper trails, regulators can check at least after the fact, and use the law to enforce fair trading.
The second part is harder to verify in a volatile market. In a sideways market, the price is less clear, than if the market is moving steadily up or steadily down. Analyzing and matching every trade and price change would keep a few computer hardware vendors in business, at least!
After working in the futures market for many years, I assumed that the stock market could use something similar to local traders, to provide liquidity. Unfortunately the short selling mechanism, when not properly regulated, may have become a license to steal and responsible for a portion of the recent stock market slide. It may have bankrupted companies, putting workers in otherwise healthy companies out on the street.
Options on stocks already provide a mechanism to buy and sell stock volatility, without having to own the stock. If the bet doesn't work out, the most the option buyer can lose is the cost of the option. Naked option selling has its risks, but it is heavily regulated.
I wouldn't be opposed to a temporary moratorium on short selling while this issue is reviewed. As a taxpayer, I want the markets to operate fairly, if I'm going to be stuck with the bill of another bank or insurance company that must be liquidated.
Unless there is confidence that the market is a fair place to trade, investors will have more incentive to keep their cash parked in mattresses.
©2008 Bob Nightingale, all rights reserved. You must have written permission from the author in order to republish this work.
Published: Thursday, September 18, 2008
Last modified: Thursday, September 18, 2008
The views expressed in this article are those of Bob Nightingale only and do not represent the views of Nolan Chart, LLC or its affiliates. Bob Nightingale is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.
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Reader Comments:
Posted By: Jahfre Fire Eater
Date: 2008-09-18 13:01:51
Hey DB, nice article.
I thought about launching into an examination of the cost of ensuring "fairness" in a "free" market but I'm not feeling well. :-)
Personally, I wouldn't enter a position unless I believe the odds are stacked in my favor. I consider myself to be an investor on a very small scale. I'm definitely not a day trader nor a speculator and I certainly would not like to see a market where "fairness" for those folks creates unfairness for me.
I'd rather let the consequences of the naked short influence play out over the long term than try to head it off at the pass with more regulation of the "free" market in the short term.
Already chaos reigns in the markets and finance. The long standing rules, roles and relationships are moot in the short term. Is this a Von Mises style "crack-up boom?" I sure don't know the answer to that but I do know that major, sudden course corrections in swirling currents aren't usually advised when rafting through turbulent waters. In my world view that It's All Related, I think the same should apply in these economic conditions as well.
Jahfre Fire Eater
Posted By: EJ
Date: 2008-09-18 13:24:11
No one should be allowed to Naked Short. A market of supply and demand where you suddenly have unlimited supply destroys the price.
Shorting where you have access to real shares to sell is one thing. Shorting where you have no access to the shares, creating an artificial supply of shares is another.
EJ
Posted By: Tully
Date: 2008-09-18 16:28:00
I'm sorry, as an Economist and Business Instructor, I strenuously disagree. Last week I heard gratuitous comments floating around blogs about how evil 'short sales' were, and this week its becoming a groundswell.
First, it is not much different from a wholesaler agreeing to sell 100 Widgets to a Retailer, and then going back and getting those widgets from producers in order to deliever on them. Delays in supply lines result in this scenario ALL the time.
More important, and to the point, Short Selling *STABILIZES* markets. If everyone is trying to dump their stock in a mad rush, the price crumbles. A Short sells what he doesnt yet own, but that *FORCES* him to go back INTO the market to pick up that stock. In so doing, shorts entering the market to deliver the goods actually increase demand for stocks that are falling in price, thus acting as a break on a stock's free fall. Without the shorts, no one would be rushing in to buy those stocks.
I repeat: Shorts so not cause stocks to drop; rather, they enter the market when stocks are already dropping, create demand for those stocks as they buy what they've sold, and stabilize the market.
The idea mentioned above that shorts should only be allowed to sell stocks when they are on the uptick is preposterous. First of all, no stock moves consistently, they are up and down, so what do you want to do? Force short sales in increments of seconds depending on where the market s for that stock?
Worse, who in their right mind would sell a stock with a rising price? That person would be forced to sell at a low price, then buy the stock at a higher price. This is not going to happen.
Posted By: James Robyn
Date: 2008-09-19 15:25:56
Here's an example of short selling.
Let's say that the short sellers have inside intel that there will be a terrorist attack using two airline companies' airlines so they borrow their stock sell it to unsuspecting investors who pay a premium for it then buy it back at a bargain price after the fore mentioned terrorist attack.
Of course this is a very hypothetical example.
I'd say instead of regulate the market. One should ask what many of these short sellers knew about the serendipitous events that transpired which allowed them to make a literal killing on the stock market.
Generally as far as I'm concerned most short sellers are vultures.
Posted By: Jahfre Fire Eater
Date: 2008-09-19 18:11:07
CORRECTION: In my previous comment I unwittingly used the term "naked shorting" when I meant simply short selling.
I agree with EJ and DB, no one should be allowed to make naked short trades and they should remain illegal. I oppose the recent ban on short selling though; that is all togther different. As a stock owner I should be able to lend my shares as I choose. As a stock borrower I housld be able to sell the stocks I've borrowed on the open market.
The only way to make money on legal short selling is if the stocks are indeed over priced. When a trader believes this to be the case they should be able to risk their capital on their belief through short selling.
-Jahfre Fire Eater
Posted By: Master C
Date: 2008-09-27 09:18:14
Dear Bob,
After reading your splendiferous ultimatum (the sappy hyperbole intended) about freedom from tyranny and rah-rah America, I can't seem to juxtapose that with your rant about naked short selling. You don't seem to understand that the stock market is a PRIVATE gambling casino. Anymore than you should be able to regulate when a player has to hit in a casino, you shouldn't be able to regulate the kinds of arcane and (as many have observed) reckless trading options that people in the stock market want to concoct.
I'm afraid your ANTI-FREEDOM PANTIES are showing! Ha! Ha! Must have been on the wrong end of a short trade.
People play the stock market just like the horse races and the casinos. It's YOUR money. Bet it the way YOU want to bet it.
BUT ~ and I make this an enormous BUT ~ YOU MUST BE MADE TO SUFFER THE CONSEQUENCES OF YOUR OWN RECKLESSNESS.
There. That's how you defend FREEDOM. And, I'm a LIBERAL! Ha! Ha! You anti-(naked)short people just don't like the way some people play the game, so you want to ban it. What's next? CDS (credit default swaps) or REITs (real estate investment trusts) ~ or, heaven forbid ~ the infamous off-shore partnerships of Enron?
Freedom has its costs, too. It isn't just a one-way street. That's what we Liberals recognize. There has to be SOMEONE making some rules. Otherwise you boys might hurt yourselves and we would have to bail you out.
Master C