Combating Cascading Short Spirals

The recent volatility in the market has given rise to some unusual trading tactics in the marketplace, in particular on the short side. One of these tactics appears to be to buy a large order of puts on a security, bid up that company’s CDS spreads, then rapidly short sell that security at a tight market moment such as when markets first open or close or right before a weekend.

This then causes a panic that triggers actual investors to sell off and leads to a downward spiral of equities selling off and credit downgrades (due to deteriorating cash funding options) that ultimately leads to a firm’s downfall. Rumors and news articles abound that such tactics were used to drive Bear Stearns (BSC) and Lehman Brothers (LEH) under.

The SEC and the exchanges need to devise ways to help combat such tactics or they risk losing the confidence of both retail and institutional investors. Arguably the single greatest thing the SEC could do to improve confidence would be to expand disclosure and transparency of information in real time on technical information, such as short interest, that indicate the deployment of such tactics. A major problem with short selling has always been the fiat share creation issue – if you borrow a share and sell it on the open market there are now additional shares floating in the marketplace in addition to whatever the firm’s actual float is. If you short enough shares, you can expand the existing float to double as many shares as you can borrow. In a covered short sale, you could in theory short up to 100% of the entire float (difficult and unlikely as it may be) and essentially double the number of shares available on the open market.

This can cause extreme downward pressure on a security as shorts can flood the particular market for that security until there are no investors left – then drive down the price with a series of small transactions to collapse the price and generate paper profits and losses. One major issue facing the market is that there has not been any disclosure regarding large short positions until the SEC’s recent efforts.

Given the recent collapse of some major firms (BSC, LEH, AIG, FNM, FRE), the marketplace is fraught with fear that can quickly become a real crisis. As a result of these two factors combining, shorts are able to generate what amounts to a crisis of confidence with their tactics and put firms out of business for their own profit.

Of course, if the market knew that the collapse in price was being caused by shorts instead of an actual panic, the market might behave differently. Currently, short interest is reported twice a month by the New York Stock exchange for the outstanding short interest at the end of the 15 day period. This information is substantially delayed however and can be easily manipulated by closing out short positions the day before and reopening the day after the report’s effective date and is not as useful in reading the types of day in/ day out (shorting a stock and covering the same day) that appears to be prevalent in the market.

What the market needs is real time information on short sales – if investors see a security collapse in price and see real time short interest surge to match the most recent levels of activity (e.g., it was shorts driving the price down), they would be more likely to stand their ground and possibly invest even more into he security given its attractive valuation level generated by the short. If combined with the SEC’s recent proposal to place circuit breakers on stock that halt trading if certain thresholds are met, you would have a situation that would essentially paint a bull’s-eye on any shorts trying to artificially drive a firm under. Investors would have the time of the trading halt to analyze both the firm’s financial information as well as technical indicators (e.g., the real time short interest changes) to decide whether to invest more. The simple act of a trading halt itself would draw attention to a stock suffering such an attack and would make obvious what was occurring.

The overall effect would be to improve confidence amongst investors about the value of their investments as they would be able to ascertain whether a particular security was dropping price due to shorts trying to artificially generate a collapse versus actual investors fire selling their shares. While there are still some loopholes around this (the usage of ETFs in particular allows a backdoor to avoid showing short interest), such information would make it substantially more difficult to cause the panicky collapses some of more recent bank failures have seen. Thus, forcing the exchanges to divulge real time short interest information could be of service in preventing some of the jackal style trading tactics afflicting the market.

Sources:

1) Cramer, from TheStreet, SEC Letter

2) Blog from WSJ

3) Bloomberg 

4) SEC Letter on Short Ban 

5.) Investor's Business Daily

Disclosure: No positions
 

Comments

[turkeyeyes:]

Let's stop the shorts in their tracks BEFORE they decimate another business.
Cox, get some balls and ban them, just like the UK and many other countries did.

2008 Oct 13 06:35 AM

[turkeyeyes:]

Actually, the so-called 'circuit-breaker' is little more than a 'short-appeaser'.
Such a mechanism allows a stock to be shorted down as much as 20% on a given day before a 3-day trading hiatus kicks in.
Shorts can gouge out up to 20% before the circuit breaker kicks in. Why should this be permissible? Over 5 trading days of continuous assault, a stock could be decimated.
If the stock is only shorted down to 19% on a given day, no 'circuit-breaker' activates.
This is not acceptable.
The SEC must ban shorts now in line with major European partners.
It's time for longterm investors to have their investments protected and for companies to be valued for their fundamentals, not devalued via lies and innuendo.

2008 Oct 13 08:21 AM

[blondino:]

yeah, and go to china if you wanna jump the pyramid game of short sellers! :DD

2008 Oct 13 09:03 AM

[Fish Gone Bad:]

The only reason to be in the stock market is to make money.

Markets move as tidal forces, money moves in, and money moves out. It is as simple as that. The trick is to be on the right side at EVERY given point in time. That said, the US Government can buy up every single bad loan and buy up every single share of every F'd up company on the stock market. This will destroy the dollar. Everything everyone has in the bank and retirement account will literally just vaporize as the dollar is inflated beyond recognition

AIG is on the hook to pay $225 Billion on Friday, 10/24/2008, in defaulted Lehman guarantees. My guess is that any company throwing lavish parties after getting an $85 Billion dollar loan, is not going to pay their obligation. This is what people who are about to "go under" do. The guy down the street from me has a drinking problem and went broke. Before he went belly up, he bought a new Chevy 2500 truck and ran up all his bills.

I am on both sides of this long/short argument. I have no idea how things will play out. That said, my best guess is that "crap happens". Plan ahead.

To anyone reading this. This is not about paper money, it is about toilet paper. In these uncertain times, please just go out and buy what you will need in the near future. Do you use toilet paper? Go out and buy a years worth tomorrow. If you "Threw your money away", it will just be for toilet paper.

I am your best friend ever (for free).
Clark Jenkins
FishGoneBad.com

2008 Oct 14 01:22 AM

[PeteK:]

Mr. Jenkins; be a little more optimistic, we only live once, you know.
Politics and the stock market give people hypertension and
anxiety thus shorten their lives. Just not worth it. It will make more sense
to spend an hour or so each day to find and point out those crooks so the public know about it. That's what a true American should do. Just like you pointed out those AIG crooks who spent taxpayers money for their party.
These are the people who destroyed a nice company like AIG and they must be kicked out or send to jail. No excuse whatsoever !

2008 Oct 14 10:50 PM

[H. Michael ...:]

Thanks for the comments all.

Turkeyeys, I agree that a short circuit breaker by itself is insufficient. However with realtime short information being made available, special situation funds could take out short attacks. If the shorts stop at 19% per day, a daily basis is more than enough time for Spec Sit funds to do their homework. The problem right now, in my opinion, is that the current time window the shorts have been using to overload the system with sell orders is too short of a time to research a company and go the opposite way. The bear raiders have the advantage in that they know how many fiat shares they are creating whereas long investors are flying blind on the fiat float.

Once a company has collapsed more than 25% in share price in one day it begins the downward spiral of downgrades and panic amongst investors and creditors.

Short selling has its uses in the market, but the current abuses on the Street require a response. The uptick rule would be nice but truth of the matter is, modern buy and sell programs can easily get around it by using computers to trigger minor upticks with a buy prior to large sell orders.

2008 Oct 16 11:29 PM