Ignored short selling events causing undeserved wealth loss by innocents. by SovereignJim
(libertarian)
Friday, December 18, 2009
I have just finished reading a long essay claiming wonderful positive effects for short selling titled "Don't Sell Short Selling Short" by Gary Galles - Mises Institute.
He ignores a major event of October 1987 that proves beyond all doubt that his defense of short selling has the same merit as Das Capital by Karl Marx. I had no position in the market at that time but did closely watch the events on a Friday, Monday, Tuesday. The market behaved like a "China Syndrome" run away nuclear reactor of movie fame. Friday it collapsed in an manner stopped only by a market close and then reopened on Monday under massive control by Greenspan of the Fed which eventually halted the collapse. One needs to understand the hedged computer buying of S&P 500 index contracts with selling of S&P 500 stocks to appreciate the events of those three days.
There is a list of 500 stocks traded on the New York Stock Exchange called the S&P 500. During each trading day there is a continuous calculation and reporting of a capital weighted sum of the last traded price for this list of stocks. It is called the S&P 500 index. There is also a continuous reported last traded price for S&P 500 index contracts which expire on dates in the future. Now consider the following facts that occurred on that Friday.
The index contract trading price is far below the actual index. This was caused by contract traders on balance expecting the market to continue its downward movement. The computer trading programs now spring into action. They quickly buy the low priced index contract and also sell S&P stocks that represent the index. The hedgers have locked in a profit because they receive more cash for the stocks sold than their cost for the index contract bought. This stock selling causes the market to continue its descent.
When the contract expiration date is reached they sell the purchased contract and buy back the sold stocks which equals a zero sum cash set of transactions because the contract value that day must equal the S&P stock index value that day. The profit is locked in whether the market goes up or down from its value at the time of the computer programmed trade. The details of how this is accomplished are complex. If fact many of the paired contract purchases and stock sales are reversed before the contract expiration if the contract price becomes much greater that the stock index before the contract expire date. Then the locked in profit is close to doubled and made over a shorter time span. This is all well and good as long as short selling is not involved.
A computer programmed hedger executing as described above must stop making trades when exhausting the supply of owned shares. That is to say they must stop trading when short selling is not allowed. The "China Syndrome" condition of the collapse will be remove because they ran out of stock inventory to sell. Programmed hedge trading is fine when selling shares owned just as the opposite case of buying shares and selling the futures contract hedge is fine. However short selling was and is now allowed. Thus such a collapse will continue until those selling index contracts change their judgment about the downward move of the market. A major drop in the market will also force additional stock selling as margin limits are hit. The loss of wealth by innocent investors and pension fund members was catastrophic then as it was in the market collapse of 2008. QED
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I have to disagree. Selling short (selling stocks you do not own, but need to go into the market to secure) is both a common type of market transaction in the non-stock markets, and a safety net that protects investors.
There is nothing unusual about being asked ot pay for a good, via an internet sale or a factory order or a construction contract, only to have the dealer then use that case to purchase the goods or raw materials necessary to complete the sale. When a trader sells a stock he does not yet own, and receives the cash and then purchases the stock, he is doing the same thing.
More important, the short sale performs an important function in *stabilizing,* not destabilizing, prices. When stock prices are falling, and the short seller sells stock (presumably continuing or accelerating the downward slide in the sale price), his action is different than the regular sell-off because he has to go back into the market to buy shares. In so doing, he increases the demand for those shares, a force which applies the breaks to a downward slide.
Lastly, if all traders are losing their shirts in a falling market, who is left to generate transactions and bring the Bull back? *Someone* needs to make money as stocks slide, so that there will still be players to generate activity. If *everyone* were to lose, we'd be in far bigger trouble than if we permit a mechanism for some to *win* as everyone's stocks are heading south. It is only jealousy - and poor economics - that insists that everyone be equally miserable.
