Don't Be Fooled - Short Selling Restrictions Do Work

I cannot believe that commentators and media analysts alike, one after the other, are publicly professing outrage over the new short selling restrictions recently implemented by the SEC emergency action. They smirk and seem to take great pleasure at pointing to the 300 plus, nearly 400 point sell off on Monday, and the follow through on Tuesday’s trading sessions as proof and example that short selling restrictions don’t work. Really?

You don’t mean to say that you actually believe that by removing the ability to short stocks, the market couldn’t trade down, did you? Because if you did, then none of these so-called “experts” even deserve to have the pulpit or mouthpiece to speak with any measure that is credible beyond a bedtime fairytale.

If you watched the selling on Monday or Tuesday, it was the first time I had ever seen such an orderly sell off without the panic inducing disruptions of forced liquidations across the board. And that’s how markets should behave, orderly, not necessarily up or down with directional bias.

In addition, the overall market was trading on relatively light volume and because of that, the price action could be arguably more exaggerated by the move. But what you didn’t have was short sellers and funds coming in and pounding the markets by aggressively amplifying the downside pressure. I would also say that another reason for a sell off, and why there weren’t that many buyers in the market, was that they were the very same ones that bought last week and Monday was more or less “profit taking,” if you could call it that, from the huge recovery late last week.

Remember back to ancient history of, let’s say, last week, when we were in serious crisis Thursday morning, sub 10,600 on the Dow and plummeting fast with no end to be seen? Goldman Sachs (GS) and Morgan Stanley (MS) were on the verge of going under like their predecessors in the investment banking sector, despite the fact they just reported net positive earnings. And the viral contagion of the credit collapse was about to spread to the other pillars of our financial system. Something had to be done to save our economy from a complete and systemic disaster.

We didn’t get back to where we are without the largest “short squeeze” ever in history orchestrated by the Treasury, Fed and SEC in conjunction with global short selling rules and restrictions. Short selling restrictions brought an end, as intended, to the bank run on the markets last week. This doesn’t mean that everything is finally resolved back to normal levels of confidence in the markets, but it did buy time to pass legislation for the Paulson plan.

Now, to be clear, if Congressional leaders fumble the ball and don’t support a plan of action to address the current credit crisis, then we have serious problems and, at that point, I would have to reevaluate my optimism in the markets.  And, surely, if the SEC lifts the restriction on short selling by allowing the ruling to expire in October, look out, ’cause short sellers will try to hit the markets with a vengeance.

THOU DOTH PROTEST TOO MUCH

Don’t be fooled, short selling restrictions do work. In fact, before Monday’s trading session, the argument against short selling restrictions was that prices would be artificially inflated or that it would be impossible to determine price discovery, and that short sellers provided a service to the markets by revealing overvalued companies so that investors wouldn’t overpay.

Right, should you believe the very same hedge funds that complain about something when they have so much to lose? I hope professional short sellers get blown out of the markets and locked out of the casino from further manipulation or capitalizing on other people’s misery. Think about it, logically, and consider the source. When professional short sellers start complaining about the rules, then they must be working. Who cares, it’s payback for bulls and what’s wrong with trampling on a “bear-skinned rug?” If very successful professional short sellers like Jim Chanos and Doug Kass complain the loudest, Shakespeare would suggest: “thou doth protest too much.”

Seems like people forgot the basic theory of economics 101, that something is only truly worth what someone else will pay for it at current market value. In the case of stocks, price discovery mechanisms are determined through meeting the spread between the bid and the ask. If no one is willing to pay the current ask price, then the price will fall if there are no bidders in the markets. Likewise, if the bid overwhelms the current availability at the ask price, then prices will rise.

Seems markets work fine to me without the exploitive pressure of short selling volumes pushing price action artificially down. That is the function of capitalism and “free markets,” without the manipulative abuses of short sellers tossing gasoline on the fire.

To me, professional short sellers–and I am making the obvious exception for market makers and liquidity providers–are like arsonists running around torching people’s homes to collect the insurance money. They induce panic by talking down the markets from their own book, and use tremendous volumes of sell orders to hit the legitimate bids in a stock over and over until they exhaust any support levels as the price falls.

I have no problem with prices falling because there is less demand for the stocks, but I do have a problem when there is this “hit list” by professional short sellers that are, literally, targeting solvent companies and driving them into bankruptcy. That behavior is not only un-American, that is unpatriotic and immoral, most importantly, it is definitely not free markets and Capitalism.

And if someone doesn’t think a company is valued correctly, then make your bet by using a “synthetic short position” by shorting calls and buying puts through the options markets. That’s fair, and I would use those techniques myself if I feel a company is overvalued and trending down, but your decision to short a position should not be predicated on the capacity for manipulation, or the inside ability to eventuate the final outcomes in the stock.

MARKET MAKERS AND LIQUIDITY PROVIDERS MUST HAVE AN EXCEPTION TO THE RULE

I’ve mentioned this before in a previous article but, to be clear, market makers and liquidity providers should be excluded from short selling restrictions so, yes, there is some legitimacy to the argument that market makers could not properly offset risk by the service obligation of providing liquidity in the market.

For those that don’t understand how this works, when you buy put protection and a market maker sells you that contract, they must, in turn, short the underlying shares to hedge their position. And the same is true if you sell a call and a market maker buys the option contract, they must short the underlying shares against the position. In effect, they are creating a neutral position that offsets risk in order to create tremendous liquidity in the markets and tight spreads on the bid and ask. They do this over and over again throughout the day to create liquidity and, essentially, utilize “gamma scalping” of premiums through very minute and precise arbitrage.

I am concerned, however, that there are market makers that also trade for their own firm’s interest. I would hate to think that this exception to the short selling rule for market makers is just another “back door” for institutions to short sell stock and drive prices down further. A lot of firms that do their own proprietary trading with their own self-serving interests also provide liquidity as market makers which could, potentially, be a severe conflict of interest. I have no problem with market makers shorting for the exclusive reason to provide liquidity in the markets, but if it becomes a loophole around the intended effect that is, whether you like it or not, working to blow out professional short sellers and hedge funds, then you tell me who has the bigger fix in the game.

So, in theory, market makers could be the back door or exception to the rule. Technically, a fund could target a stock by buying extraordinary amounts of long put contracts and forcing market makers to hedge risk by shorting the underlying stock, essentially, bypassing the rules to use liquidity providers as the surrogate for the fund’s original intention to drive prices down. Such intentions should absolutely be illegal if done in a concerted effort to manipulate the markets and, in all seriousness, could be difficult to prove in the end.

LIMIT UP, LIMIT DOWN

A quick note on Monday’s oil action in the futures markets: Crude spot prices jumped over $16 to settle at $120.92 at the close based on no fundamental reasons at all. This was blatant manipulation. Yes, it was a short squeeze against open and existing October contracts due to expire imminently. With extreme backwardation and price dislocation because of the November contract that was rolling over to the new spot price the very next day that didn’t reflect the squeeze. Only about 30,000 contracts traded, less than 1/10th of normal volume and less than the November contract of nearly 300,000, which was trading at a much lower price.

Regardless, the CFTC needs to regulate this or governance needs to occur so that we cannot allow oil to be pushed back toward 150 without breaking the back of the American economy. The fundamentals are not there to justify such price manipulations and it is financial impairment to the livelihoods of all Americans.

If you ever wanted proof of manipulation in crude prices, this was it and it’s there for everyone to see, even if you put your blinders on and didn’t know how read Braille…

Stock position: None.

Comments

[Poncho-san:]

Not one mention of reinstating the uptick rule. This, to me, was the most obvious change that was needed to keep the "professional(?)" short-sellers from driving down prices to unrealistic levels. Typical knee-jerk reaction from our government is to "ban" unpopular behavior.

2008 Sep 24 07:28 AM

[Online Trading:]

You make some interesting points, but are you as passionate about bulls driving up a price to ridiculously high PE's when the company is not worth it?

Should we therefore ban buying when a stock reaches a certain PE/price? The problem with taking a 'legitimate tool' (as the UK FSA call it) out of the market, is that you have to look at the flip side.

Like they say, when it comes to God and Satan you can't believe in one, without believeing in the other.

2008 Sep 24 08:08 AM

[sponger:]

On the surface it appears to me that suspension of short sales for financials has provided a short covering rally, sufficient for some long investors to partially or fully recover, at which point they have or will sell.
The question is to whom do they sell? Only the market makers? How much inventory can market makers absorb? My question is what prudent fund manager would invest in finance equities if he cannot hedge his position by protective puts? A spread of long financials and short the Dow or something like that will not meet the protection requirement standards of many mutual funds, pension managers and conservative investors of a large scale. Consequently, it seems to me that suspension of short sales removes .buyers from the market, creates considerable slippage in volume, and in the long run leads to lower capitalization. In so doing it also contributes to more rather than less volatility in the finance sector. I have big gaps in my Economics and Markets 101 education, so maybe I am entirely off base on this, but if so I would like to be corrected by those who kjnow better.

2008 Sep 24 08:43 AM

[BJS:]

I totally agree with the author of this article. We have all seen big sell offs triggered by someone selling which results in others selling just because they have entered stop loss orders or short sales irregardless of the worth of the underlying stock. It has turned the market into a casino.

2008 Sep 24 08:45 AM

[wetwillie:]

I disagree!!! I do agree that naked short selling needs to be prohibited and the uptick rule needs to be put in place but short selling does provide balance in the market. After all, with nornal short positions it does provide some level where there are willing buyers.

2008 Sep 24 08:56 AM

[JoePass:]

Seems to me that the issue is naked shorting.....if institutions or wealthy individuals are able to naked short millions of shares without impunity, a stock is defenseless without regard to fundamentals. The Bush Administration has gutted the SEC so that they are understaffed and therefore can't discover nor prosectue the perpetrators. I think that shorting of financials was stopped because the SEC knew they couldn't stop the naked shorting.

I'm a believer in shorting and that it's important for liquidity and valuation discovery purposes (btw, where were the shorters in 1999?)......naked, unrestrained shorting is deleterious to orderly markets.

Another thought.....looking at the returns of hedge funds during 2008, I wonder who are the true perpetrators of naked shorting? The average hedge fund is not performing well in a season of rapid, huge profits from shorters.....so, who is actually doing this? If this issue isn't fodder for an investigation, what is?

2008 Sep 24 09:36 AM

[johnm:]

It could very well be that the short selling of financial shares is not a
bear raid or some deliberate attempt to dirve down the share price but
simply someone's hedge for a large CDS position.
Unfortunately this type of hedges generate a negative feedback loop
if the CDS notional is large (shorting stock to hedge against the probability of default depresses the prices increasing the probability of
default therefore needing more shorting).
The move to regulate the CDS market should fix this to some extent.

2008 Sep 24 09:44 AM

[Tony Daltorio:]

Let's be fair. How about also banning the obvious and blatant "mark ups" on stocks that occur at the end of each quarter by fund managers? Or is
"manipulation" ok on the upside?

2008 Sep 24 10:06 AM

[carey_jim:]

Why not just halt trading in financial stocks (and any other troubled sector) altogether and peg prices at what a panel of experts think they should be?

The market is a dangerous place.

2008 Sep 24 10:20 AM

[simplesimon:]

Excellent article -I'm tempted to say silver lining back lighting some dark clouds. I too was astounded to see such ire re. the temporary ban on short selling...at least long enough to reinstate the uptick rule; and perhaps add a few detectives (at the SEC ) to discover/ uncover collusion. Things are different now with, as one contributor described it, whippersnapper dufusii with a blackberry and a lunch break hitting the panic sell button as he sees his share price slide. We like to pride ourselves on being against the govt. - but they are applying every tool in the box to stop the slide/panic. I remember when the DJIA was below 8,000. Should valuations fall back to that? Would you still blame your current whipping boys, Paulson and Bernanke if that happens, and without any remedy it certainly will.
When will any of us blame ourselves. We're the ones who thought we'd all move to Boardwalk and Parkplace with our Humvees, 50 miles or more from town....with our high maintenance women drooling over the Sex and the City designer outfits, and charging it all on high interest charge cards. Credit cards, by the way that your Congress approved laws that allow them to charge you 30% interest if you are late with another creditor? Or allow GMAC to repo your car for only 30 days arrearage,and sell it to Carmax , on a short sale, and legally be allowed to bill the previous owner the difference, and keep the 'profit' for yourselves?....Isn't this similar to short selling? Isn't this like "I'll borrow your car, without your knowledge, bash it up, then sell it, and keep the difference between its former value and the bashed up value?
Yes...we hear a chorus of short sellers crowing about the valuable service they provide re. "true valuation". But trust me, the vast majority of us see these institutional short sellers as grand theft auto repo kings, snorting and chortling with slobbering greed and utter disregard for any 'weakling' who gets in their way to Boardwalk and Park Place.
Keep boasting of your right to naked short selling, so we can identify you , round you up, and send you to camp......camp penitentiary.

2008 Sep 24 11:15 AM

[Njord Wind:]

Wait a minute - your premise is essentially "I thought the market declines on Monday and Tuesday were more 'orderly' than those of last week and therefore the short ban is 'working'" ("orderly" and "working subject to one's own definition). Sounds more than a little tenuous. I'm also extremely skeptical of the idea that there is a way that markets "should" behave.

Remind me again how short sellers cause solvent companies to go BK? Did short sellers cause LEH to lose billions of dollars? Don't be stupid, these companies got themselves into trouble.

While it might look good in your textbook, there are large differences between a short position and a synthetic short position made via options.

What do you expect Chanos and Kass to do? Sit by and accept it? The SEC is legislating their business models out of existence - you'd better believe they're going to protest it.

Naked shorting has always been banned, should be banned, and the ban should be enforced. I'd also be fine with them bringing back the uptick rule. But this heavy handed ban was brought down so people could think the SEC was "in control", only to later discover the thing was so hastily implemented and crudely constructed that the SEC was clearly as out of it as ever. It's caused ill-concieved havoc in the stock loan, ETF and options world. That said, I would fear its expiration, because we are indeed in a manipulated market at the moment, and look out below when the ban comes off.

2008 Sep 24 02:44 PM

[wise invest...:]

Short sellers are clearly the trigger for a lot of this problem. I would agree that fundamentals were problematic but not it become something even bigger than anybody imagined.

I don't blame short seller on bad companies but takin the whole market out and shooting it? That's illegal.

2008 Sep 24 04:10 PM

[Old Wizard:]

Is it always true that stock prices are only affected in a one to one relationship buy to sell or can a stock price be forced lower by suddenly having more sell offers than buy offers? If the latter, can a big short sale offer alone result in the significant lowering of the stock price? If the answer is yes, then given the leverage the big funds have, manipulation could easily take place. I generally think that a marked decrease in all leverage vehicles especially in commodities should be in place and believe for oil in particular the margin requirements should be increased to 80 cents on the dollar.

2008 Sep 24 05:30 PM

[Zekeko:]

My my my this is really truthful about short selling. Uptick is a sham when it comes to decimals.

Ban short selling all the way. Look how orderly the markets have been like this author stated, not volatile. Yeah, down, but not crazy selling pressure like last week and now all the financials are still in business. something must be working.

2008 Sep 25 12:00 AM

[User 257960:]

"If you ever wanted proof of manipulation in crude prices, this was it and it’s there for everyone to see, even if you put your blinders on and didn’t know how read Braille…"

Sorry, it is not the short sellers that are to be blamed. It is an unitended consequence of the govenment manuiplation in poping up Wall Street. Certainly the Bernanke and Paulson did not have a clue and they still don't get it. I still remember Paulson stating that the oil run up being 'supply and demand'. I think we have given them enough opportunity and time, and each time it proved that they are wrong and have no glue. It is time to change direction, take the pain and let the phoneix rises.

2008 Sep 25 10:16 AM

[Long beta:]

100% correct! Outside of market making short sells should be banned- or strictly limited as they offer very little in mkt stability or true price discovery- short sellers belong in Vegas NOT a developed market.

2008 Sep 25 11:01 AM

[iNVestorUnrest:]

crush the shorts

2008 Sep 25 09:47 PM

[Tony Petroski:]

Crude oil went from $75 to near $150 in less than a year, a year in which demand for oil in the U.S. went down 4%. We kept hearing about insatiable demand coming from China and India driving up the price--as if those folks were immune from the laws of supply and demand. Then the price of oil collapsed to under $100. Now it's fluctuating wildly again. This is obvious manipulation of the market (that is not to say that those doing the manipulation can't get burned badly once in a while).

As to the short selling: I watched two financial institutions a week targeted and ground into dust through short selling and panic. American Airlines sold off about 33% in a matter of minutes on a phony news story posted in Florida that I didn't even hear about until American Airlines had already recovered.

Orderly, efficient markets? The market reminds this novice more of a casino than a stock market. There will always be manipulators under any rules you care to set up, but please spare me the idea that the manipulators provide liquidity or an orderly market or any public service whatsoever.

2008 Sep 25 10:07 PM

[akapital:]

naked short selling is the true culprit and enforce the uptick rule.

I personally seek out short squeeze opportunities so I appreciate when shorts go bad...which of course means that I support short sellers in principal. I believe that they are entitled to take a short position so long as shares are available to borrow. But when one sees volume turnover like we have recently in some stocks it indicates that there is naked shorting...sometimes in excess of the entire float of the stock....that should be illegal.

2008 Sep 26 06:13 AM

[dumbmoney:]

The companies that the so-called "shorts" are targeting deserved everything they got. They were exponentially levered in extremely risky assets that are declining in value. Very simple...end of story. The "shorts" were successful and profitable because they were right. The "shorts" would not have succeeded if they targeted companies with sound balance sheets and high quality earnings. Did LTCM fail because of the shorts? In 2003, Warren Buffet called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." Obviously he was right. Your focus should be on the regulators that sat idly by, while Bear, Lehman, AIG, FNM, FRE and others put our entire financial system at risk. Regulators, Rating Agencies, Mortgage Originators, Bond Insurers etc...there are many culpable parties here......none of which is the short sellers.

Capitalism works...but only if you let it.

2008 Sep 26 10:55 PM

[danf:]

Someone please educate me on shorting. Someone is "borrowing" my shares right and then selling them to buy back later at a different price.

Seems like I should have the ability to direct the safekeeper of my shares not to lend them. It also seems like I should be entitled to being paid rent by the short seller who has borrowed my shares.

It seems like those 2 changes along with the uptick rule change would truly level the playing field.

2008 Sep 27 06:16 PM

[Matt Blackman:]

C.S.Jefferson has just proven beyond a reasonable doubt that he has no clue how markets work.

2008 Sep 28 05:03 AM