Short Selling Ban Welcome

It is amazing how much controversy there is surrounding the ban on short sales in certain financial stocks. Such a ban is welcome and long overdue.

Those who believe the government is taking away their market freedom by not allowing short sales are ignoring the fact that "freedom" and "manipulation" are very different. There is nothing wrong with borrowing stock to short, but in many cases this has not been happening.

Blogs have abounded for the past decade with complaints about "naked shorts," where manipulators have conducted bear raids on stocks and hammered companies into oblivion to make a quick buck. There has been little or no enforcement by the SEC against naked shorts, probably because enforcement is not practical.

Massive short sales with covering later the same day, use of "failure to deliver" certificates from offshore brokerages and other tricks make discovery of naked short selling difficult. Also, under the laissez-faire policies which have prevailed for a number of years in the markets, nobody is interested in the fate of a few companies or a few investors who have been victimized by the manipulators. It is only now, when the bear raids affect giant financial institutions, that the SEC is taking notice.

The uptick rule, where short selling can only be done after a rise in stock price, was abandoned a few years ago. Although this rule is largely irrelevant in today's markets, it should have been retained anyway, if only for appearances.

Unfortunately, manipulators might be able to short huge amounts of a stock in one block, buy back a few shares a tick higher, and then short another large block. Since many trades are computerized, the uptick rule has little effect except to alert investigators (assuming there are any who care) retrospectively if abuses follow too obvious a pattern.

Let's take an example where naked shorts might be involved, although I do not accuse anyone of wrongdoing. Recently American International Group (AIG) traded over a billion shares in one day, as the stock price plummeted. Since according to Yahoo! most of AIG's shares were held by financial institutions and insiders, it would have taken divestitures on a monumental scale by multiple companies to reach this volume.

Although it is true that the upcoming end of the calendar quarter could certainly affect investment decisions by mutual funds, it is difficult to believe that AIG's share price could be punished so severely through normal trading. It would not surprise me to discover that naked short selling took place. If anyone can find a way of reviewing the trades of the major holders in AIG during the billion share day, that would be helpful.

There is nothing that short selling provides which cannot be done through put options, albeit at slightly higher cost, due to the options premiums and the bid/ask price spread. Those additional expenses help keep down "churn" type trading of options around small share price differences. Options markets are also far smaller than share markets, at least for now, so massive put positions cannot be entered nearly as rapidly as massive short sales.

In summary, the ban on short sales is welcome and healthy for an orderly market. It should be made permanent and implemented for all stocks which have options available. The only people seriously disdvantaged by this ban are those who seek to manipulate the markets, and for them I have little sympathy.

Disclosure: I am long AIG with covered calls and am long AIG bonds.

Comments

[PeteK:]

AIG is a great company and it provides so many jobs worldwide. For a few individuals who don't understand the consequence if this giant collapse it will affect millions all over the world. Also, it will cause tons of damage to the American people and economy. The government has done the right thing.

2008 Sep 22 03:55 AM

[Shorts Are ...:]

I agree. Why give anyone, especially huge secretive hedge funds, incentive to destroy our financial systems and markets and then reward them? Shorts would have no need to spread false rumors and panic if short selling was not allowed. That is insane.

Shorts must be very evil and greedy people that strive for the destruction of man-kind. They dream for the death of individuals, job losses, and all bad things in general.The crazy thing is that they get rewarded if their dreams come true.

2008 Sep 22 04:08 AM

[Carousel:]

Dr. Byrne warned us years ago of this coming crisis. See a short compilation of his public comments here:
www.youtube.com/watch?...

2008 Sep 22 08:33 AM

[tomterrific:]

As Wilbur Ross on CNBC today said. Banning short selling is a terrible precedent and irrational. If you don't understand that there is little you will understand and the best thing for you to do is to get out of this business.

2008 Sep 22 09:51 AM

[winindthedust:]

The ban on short selling should be permanent and across the entire market.

During this instant communication age, there is just too much manipulation that can happen by shorting, then start a negative ( or false) rumor.

2008 Sep 22 10:54 AM

[34CD77:]

A question for Phillip...or anyone else. My schooling says that if I want to sell a stock someone must buy it. Who were the buyers? Naked selling is the only way that I can figure to sell without a buyer. Obviously, I am wrong but I would be interested in the answer. Thx in advance

2008 Sep 22 11:41 AM

[FOC options...:]

Javast is wrong about how short a short call is. Because calls have limited downside potential/risk, this is not at all the same as going short stock. Selling calls against long stock is a proper investment strategy called a "covered write" as you are writing a call that is covered by long stock. You are still at extreme downside risk, offset only a small amount by the cost of the call -- mostly you limit your upside potential. Options (calls and puts) are not part of the short-selling ban. This is not to say the author is not self-serving wanting the short-selling ban to protect his long position (unless you also buy a put, long stock plus short call is still a long position).

2008 Sep 23 03:55 AM

[williambanzai7:]

How The Grinch Almost Killed Wall Street
(How the Grinch Stole Christmas revised by
William Banzai7)
williambanzai7.blogspo.../

Every Banker down on Wall Street Liked CDOS a lot...
But the Grinch,Who lived just north in Greenwich, Did NOT!
The Grinch hated those investment bankers for a whole list of reasons!
Now, that is why we are having this exciting fall season.
It could be his trader head was screwed on just right.
It could be, perhaps, that his white shoes were a little too tight.
But I think that the most likely reason of all,
May have been that his NAV was 12 sizes too small.
Whatever the reason, His smarts or his shoes,
He stood there last week, hating all Wall Street's Whose Whos,
Staring down at his trading P&L with a sour, Grinchy frown,
Detesting those warm lighted screens in Wall Street town.
For he knew every Captain down in Wall Street beneath,
Was busy now, trying to sail through the great Subprime reef.
"And they're firing their traders" he snarled with a sneer,
"In three months its Christmas! It's practically here!"
Then he growled, with his Grinch fingers nervously drumming,
"I MUST find some way to give those investment bankers a drubbing!"
For Tomorrow, he knew, all the Whose Who of Bankers,
Would wake bright and early. And rush to save all their bonus earnings!
And then! Oh, the noise! Oh, the Noise!
Noise! Noise! Noise!
That's one thing he hated! The NOISE!
NOISE! NOISE! NOISE!
Then the Whose Whos, young and old, would all fly Far East.
And they'd try to talk Korea and China into feasting on trading book yeast!
And they'd feast! And they'd FEAST!
FEAST! FEAST! FEAST!
They would feast on champagne and rare banker roast beast.
Which was something the Grinch couldn't stand in the least!
And THEN They'd do something He liked least of all!
Every Who down in Wall Street, the Bulls and the Bears,
Would stand close together, with opening bells ringing.
They'd stand hand-in-hand. And the Whos would start singing!
They'd sing! And they'd sing! And they'd SING!
SING! SING! SING!
And the more the Grinch thought of this Singing,
The more the Grinch thought, "I must stop this whole thing!"
"Why, for year after year I've put up with it now!"
"I MUST stop a Wall Street bailout from coming! But HOW?"
Then he got an idea! An awful idea!
THE GRINCH GOT A WONDERFUL, AWFUL IDEA!
"I know just what to do!" The Grinch laughed in his throat.
And he made a some quick calls to spread rumours of a giant toxic CDS boat.
And he chuckled, and clucked, "What a great short seller trick!"
"With this phone and this screen, I'll batter those Wall Streetwalkers selling asset backed tricks"

"PoohPooh to the Whose Whos!" he was grinchishly humming.
"They're finding out now that no Chinese White Knight is coming!"
"They're just waking up! I know just what they'll do!"
"Their mouths will hang open a minute or two,
Then the Whose Whos down in Wall Street will all cry BooHoo!"
"That's a noise," grinned the Grinch, "That I simply MUST hear!"
So he paused. And the Grinch put his hand to his ear.
And he did hear noises over the trading screen glow.
It started low. Then it started to grow.
But the sound wasn't sad! Why, this sound sounded merry!
It couldn't be so! But it WAS merry! VERY!
He stared down at Bloomberg and Reuters! The Grinch popped his eyes!
Then he shook! What he saw was a shocking surprise!
Every banker down in Wall Street, the Bulls and the Bears,
Was singing! Without any White Knight at all!
He HADN'T seen a Big Federal bailout coming! IT CAME!
Somehow or other, it came!
And the Grinch, stood puzzling and puzzling: "How could it be so?"
"It came with out tickers! It came without a tab!"
"It came as Federal largesse in boxes and bags!"
And he puzzled three hours, till his puzzler was sore.
Then the Grinch thought of something he hadn't before!
"Maybe a Bailout," he thought, "is not just for financial Whooers"
"Maybe Fed bailout...perhaps...me... a little bit more!"
And what happened then? Well...on Greenwich Main Street they say,
That the Grinch's taxes grew 12 sizes that day!
And the minute his wallet didn't feel quite so tight,
He whizzed with his Lexus through the South Bronx morning light,
And he met those Wall Street boys for a Smith & Wolensky feast!
And he, HE HIMSELF! The Grinch carved the beef!

2008 Sep 23 05:48 AM

[mikesa69:]

FOC options trader: Javast is the most sane voice here. Your voice sounds suspiciously like you're a perma-bull who's talking his book, just like the author. What you fail to account for in your erroneous statement (that a short call is not the same as a short stock position) is indeed the primary point made by Javast. Perhaps it was too obscure for you to comprehend. Who do you think takes the other side of the sold-call trade? The options market makers. Do you think they'd allow an uncovered position on their books simply to fulfill their obligations in facilitating liquid markets? No way. So once they are long the call contract(s) they must then offset that position to remain delta-neutral. How do they do this? By SHORTING the stock. Remember (or perhaps in your case learn) that each call contract represents 100 shares of stock, so this can add up to huge short positions, contrary to what you suggest. Thank God the SEC at least allowed the market makers to go short or this market would be even more artificial.
The entire short selling ban is a bandaid at best, and is indicative of the serious trouble yet to come in the financials, else the blatant market manipulation that the various gov't agencies are perpetrating would not be required. Free markets? Bah! Welcome to the USSA my friends. What our comrades in high places have really done amounts to removing liquidity and freedom of price exploration from the markets in a very artificial way. Anyone who believes that the shorts caused these companies' stocks to tank probably believes that wearing a sweater can cause a snowy day.
Oh, and if you really listen to what the message of the ban is really telling you, you'd be doing all you can to get short and stay short this market long term, ie- through 2013 or so. BTW, the uptick rule being dead and gone is good riddance, and wouldn't help here anyway, especially since we've now gone from fractional to decimal pricing.
So good luck to all of you perma-bulls... I truly appreciate you all helping fund my trading account on such a regular basis. Hope is such a great strategy. For losing on a consistent basis, anyway. And before anyone suggests that I am a perma-bear, I'll just state that I'd rather be making money in a raging bull market that's representative of a growing economy. But when that's not the case, like now, then the manipulators (our "leaders") are only impeding my ability to make money in the market and to feed my family when they institute these gimmicky short selling bans.

2008 Sep 23 11:10 AM

[Phil Anthropy:]

I appreciate the comments, including the condemnatory ones, about this article. To clarify my AIG position for the record, I bought a small position in AIG at around 4.65 as a trade a week prior to September options expiration, because the AIG September 5 covered call that day was 1.35, a huge risk/reward ratio for only a few days holding. I figured that AIG would be similar to Bear Stearns in being "too big to fail," and recalled that Bear stock fell but then recovered. Two days after I bought AIG, the stock price had fallen to under 2 on trading of over a billion shares. I was prepared to lose the entire amount of my trade, since I was aware of that risk when I bought in. When the bailout came, AIG stock recovered. I sold out for a few cents more than my purchase price (the stock has since gone higher) and also kept the premium from the covered call after the option expired worthless for the buyer. It is correct that the short sale rule did help me, and it would have been better if I had written the article after divesting. However, now that I am out of AIG, I still hold the same views. My profits in the AIG trade were small, and I hope readers will believe me when I say that my motivation for the article was a genuine opinion..

I do not regard covered calls as related to short sales, particularly naked shorts. Covered calls are a bet that stock prices will stay the same or go up a little but not much. Buying a put option is like selling short, but I am not opposed to that, because the bid/ask spread and other factors mentioned in the article mitigate attacks on a stock's price through buying put options.

If a short seller sells massive amounts of stock into the market, the price will go down quickly. Buyers interested in the stock at the lower price come into the market to acquire the shares. The more stock that is sold or sold short, the lower the price will go. As investors watch the share price plummet, they panic and sell their holdings, adding to the downward cascade. When the price has been driven down far enough, the shorts "cover" their positions by gradually buying stock. The price will indeed rise then as the demand increases, but the shorts are betting that their average purchase price will be less than their average short sale price. At times, other hedge funds that are not short the stock come in at the bottom with massive purchases, driving the price up and forcing "short covering" purchases that accelerate the rise. The long folks then gradually sell out towards the top. The difference is that a long play doesn't destroy the value of the underlying stock by erasing billions of dollars of market cap. Short sales can and do.

2008 Sep 23 12:55 PM

[mikesa69:]

Re: "The difference is that a long play doesn't destroy the value of the underlying stock by erasing billions of dollars of market cap. Short sales can and do."
Yes but a short squeeze ADDS billions of dollars of market cap, at the expense of the squeezed shorts of course, but no one ever seems to complain about that. It's a double standard, that's all. Ever ponder the Fed's timing of these major announcements? I am not a proponent of manipulation of any kind; from the gov't OR from unscrupulous hedgies. As long as the appropriate regulations and punishments are in place to protect against that very impropriety, then I see no need for manipulation of the free markets from either side.
Thanks for the article... I think it helped stimulate conversation with some very valid points from all sides.

2008 Sep 23 02:50 PM

[Phil Anthropy:]

Further clarification for current full disclosure: Although I am out of AIG stock, I still hold AIG bonds, which I bought early in 2008 for the dividend. They are a long-term holding, not a trade.

2008 Sep 24 05:32 PM