An In-Depth Look at Short Selling

 |  Includes: ADBL, KKD, MSO, OSTK, TRMP
by: Roger Nusbaum

roger nusbaumRoger Nusbaum submits: A reader asked for my take on the naked short selling issue that is explored in a video you can watch here. It's a long one; I watched the whole thing.

I go months at a time without thinking about this. This means very little to the vast majority of stocks. Most of the stocks mentioned in the video (like Krispy Kreme (NYSE:KKD) and Martha Stewart (NYSE:MSO)) are all very hot potatoes facing big problems, real or perceived.

There are some very strange things with the video that need to be mentioned.

Early on in the video, an expert from a company called gives his take from what looks like the offices. During the video, there are two one-minute commercial breaks. Whose commercials? Ahem, I find that strange. Am I the only one?

There are also a couple of mechanical issues with regard to selling short that are not mentioned that need to be explored and explained to get some sense of how important or not naked short selling is.

First, there was no mention of the uptick rule. Stocks (as opposed to ETFs) can only be sold short on an uptick. But it is more complicated than that. For NYSE stocks, not only does the last trade have to be an uptick, but also a given short sale cannot itself create a down tick. Think about that for a moment; getting a fill can be difficult, even market orders to sell short can go unexecuted.

To sell short a Nasdaq stock the bid has to be on an uptick. I have never been too clear, given these mechanical issues, how a stock can be pushed down in the manner described. I am not saying it does not or cannot happen -- I am saying I am not sure how.

One way it could be done would be if these orders are entered as straight sales as opposed to short sales. When you place an order online, you choose from buy, sell or sell short. So if they mean that orders are being entered as sales, OK, but the video never said this. In fact toward the end one person named Breen specifically refers to short sale orders, implying they are entered as short sales.

Now there are 1000 stocks that are uptick exempt. I did some digging, and it looks like the 1000 stocks come from the Russell 3000 -- but feel free to correct me. Several of the stocks in the video are in the Russell 3000 index. Stocks that I found in the Russell 3000 from the video were Trump Entertainment Resorts Inc. (TRMP), KKD and MSO. I did not find Inc. (NASDAQ:OSTK) or Audible Inc. (ADBL). There was a penny stock or two mentioned that are not in the Russell 3000. I scanned the Russell 3000 page to find these names. Since all the stocks in question are below $1 billion in market cap, I doubt they are uptick exempt -- but feel free to comment.

A lot was made in the video of phantom shares. One thing never mentioned is that legitimate short sales create phantom shares; here is how this works:

Joe owns 100 shares of International Business Machines Corp. (NYSE:IBM) in his margin account, and he has a margin debit in the account, meaning his shares can by hypothecated for a short sale. Bill wants to sell short 100 IBM and borrows Joe's shares. All the uptick business sorts itself out, and Bill executes his order to sell short. Well, someone took the other side of Bill's short sale, and now he owns 100 shares. The company did not create more stock, yet where there were 100 shares long in one account, now there are two accounts that each have 100 shares.

I can see where reading about this would make anyone nervous, but this strikes me as being very similar to CEOs having to certify earnings reports from 2002 and the options expensing issue of the last couple of years. With both of those there was way more bark than bite, and I expect this will be no different (I first wrote about thinking options expensing would be of minimal importance in December 2004). This is not to deny it exists, but it is to question the impact it will have on stocks beyond a handful of names.

I do not have many answers -- but I know what questions to ask. The Bloomberg video comes up way short of asking the right questions (and why on earth did they place ads from someone who is a part of the story?).

One last thing: In the video Jim Chanos said that if there is an issue, it is with the prime brokers. This was not really explored. Clearly some portion would have to rest with the prime brokers. I don't know how much is their fault -- 5%? 95% ? Who knows? The video did not explore this either.

A thorough dissection of the mechanics has to accompany this in order to sort it out.

I started out saying I go months without thinking about this and after watching the video that is unlikely to change.

This could whip up a lot of comments and some good discussion.