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It’s good to short

This entry was posted by Sam Jones on Friday, July 18th, 2008 at 9:55 and is filed under Capital markets, Hedge funds, People. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

1. Jul 18   14:39 Posted by James [report]

   Some points to consider:

   1. The order did not initiate a ban on naked short selling, which already exists. It added a before the fact afffirmation between the short seller and his broker that the requisite shares are available to borrow. Current industry practice for these stocks, all “easy to borrow”, is for the short seller to ascertain that a stock is on the easy to borrow list, and then initiate the short. For anyone other than a market maker, this is likely to be a mere documentation issue that adds a few seconds to a minute to completing a trade.

   2. There has been no discussion of the issues presented by the manner in which equity securities clear in the U.S. , continuous net settlement. CNS creates all manner of issues in tracking who might be failing to receive/deliver shares on a granular basis, and makes “naked” short sellers difficult to spot in the short term.

   Provided that large institutional money managers do not remove their long inventories from the stock lending pools, and market makers continue to receive their pre trade locate exemption, I do not think the emergency order will have much net effect.

2. Jul 18   14:16 Posted by bsb [report]

   can we please please please please stop the confusion between short selling and naked short selling?

   the first is essential to a free and fair market, as cicero explains nicely below. the second is market abuse, already illegal, but not enforced (until this point). what the SEC have said is that they will now start to enforce their own rules for *certain* stocks. shouldn’t they have been enforcing their rules from the start?

   the reason naked shorting is possible is the 3 day stock settlement period - which goes back to the days when stock certificates were physical pieces of paper. nowadays everything is electronic. in these times of instant funds clearing, why is there still a 3 day settlement period for stocks?

   naked shorting is counterfeiting, plain and simple, and it has to stop.

3. Jul 18   13:24 Posted by Kamekon [report]

   Re: shorting and panics
   A recent academic study concluded that “while we find strong evidence that market returns are more negatively skewed in markets that permit short sales, we also find that negative extreme returns do not become more frequent. That is, shorting is associated not with more frequent negative extreme returns, but rather with extreme returns that become more negative. This is consistent with the idea that short selling does not cause a crash but may affect its magnitude.” (Bris et al, “Efficiency and the Bear: Short Sales and Markets Around the World”, Journal of Finance 2007, 1029-1079).

4. Jul 18   12:54 Posted by fugger [report]

   Re G Cox
   That is one story for how markets work but I am not aware of any academic studies showing that allowing short selling increases volatility. There are quite a lot of academic studies showing that banning short selling (i) means prices adjust to news more slowly (ii) make price bubbles more likely. Your story makes most sense for me over very short time periods eg intra-day when pressure of selling and short covering can no doubt affect prices temporarily. But I think the profit from shorting comes mostly from identifying shares that are fundamentally overvalued rather than ‘forcing prices down faster and lower’. Maybe that is just because I am in the (apparently dwindling) group of people who think free markets are reasonably efficient at bringing prices into line with fundamentals. The SEC ban on naked short selling seems to me mostly a move against high frequency momemtum traders that may short a stock and look to take their profit by the end of the day ie never going to settlement. Longer-term short funds that look to sell stocks that are fundamentally over-valued with an expected holding period of months or years should not be especially inconvenienced by having to pre-borrow.

5. Jul 18   12:52 Posted by cicero [report]

   G Cox, the huge profits come from someone else’s losses, not necessarily from shorting forcing prices down faster and lower.

   Equities are NOT a zero-sum game. As you say, if market cap of a company goes from £10bn to £1bn, then £9bn of value have been destroyed and the market has collectively lost that much.

   However, short selling is indeed a zero-sum game. If there were hypothetically one share in a company, and I borrowed that share from the only shareholder and sold it, I would sell it to a third individual (possibly to the same original shareholder himself). So, before the short sale there was one long position; after the short selling there are two longs and one short. The net amount is hasn’t changed.

   Now, if the share falls in value from £10bn to £1bn, the original shareholder loses £9bn; having sold short, I make £9bn, while the person I sold the borrowed share to loses £9bn. My gains and the third person’s losses perfectly offset each other - that’s where my gains come from. It’s no different from spread betting.

   The only unpalatable feature of short selling is that if a lot of people bet on shares losing value, they may indeed drive that value down. But it’s been largely shown by academic research that markets with no or little short selling are more prone to develop bubbles (housing anyone)? So short selling does play a valuable role in enhancing financial markets efficiency.

   It’s not short selling that is the problem, it’s market abuse. And that should be prosecuted both on short side as it is on the long.

6. Jul 18   12:31 Posted by Reggie Perrin [report]

   anyway…the market is going up

7. Jul 18   12:30 Posted by Kamekon [report]

   Sam - good points, but I think it’s worth making two additional ones, obvious though they may be. First, “boomtime for the shorts” means bust-time for stock lenders who are long the shares (unless hedged). Stock lending doesn’t change that as there is no transfer of economic risks. And secondly, as there is no “pre-borrowing” by naked shorts, stock lenders don’t get any fee income from naked shorting (unless there is post-borrowing pre-settlement of course).

8. Jul 18   11:09 Posted by G Cox [report]

   Without suggesting that shorting can or should necessarily be banned outright, it is worth asking where the huge profits come from. Normally equities are a zero sum game (rights and buy backs complicate).

   In a no-shorts world, the shareholders in a bank whose capitalisation falls from £10bn to £1bn have lost £9bn. If during that period the shorts make £1bn in net profit, where has that come from?

   It can only come from the shorting forcing prices down faster and lower , encouraging more buyers that there would otherwise have been and the losses sustained by those extra buyers pay for the shorts’ profits; for the existing shareholders certainly don’t.

   When the successful shorters exit near a bottom, made lower and steeper for their activity (eg Wednesday morning), they are probably taken out in effect by extra sellers that are panic selling because they think there is new insider information in the market and would not have sold were it not for the effects of the shorting frenzy that often surrounds a nadir.

   Whatever the underlying bad fundemental news, shorts undoubtedly increase volatility and send prices lower that they would get to otherwise or they wouldn’t be able to make any profits. Manufactured rumours by shorters make it even worse.

   And all the above applies in reverse to levered buying at the top of the market.