Short Selling Levels Down. Is This a Surprise?

by: David Enke October 25, 2008    

David Enke

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It appears that short selling levels have receded at both the NYSE and Nasdaq in the first two weeks of October, falling 8.3 percent on the NYSE and 10.5 percent on the Nasdaq (see WSJ article). As quoted in the article:

This decline in short interest, particularly the decline in brokerage stocks, is a continuation of a 12-week trend. Shorts have been large net buyers and therefore stabilizing these stocks, calling into question the rationale behind the SEC's ban on shorting.

You ban short selling and it results in less shorting and more short covering. Is this a surprise? As for refuting the rationale behind the SEC decision, I am not sure the trend is really calling the ban into question. If anything, the trend supports the decision (even if for other reasons it was short-sighted - no pun intended, see previous posts here and here).

Of course, one could argue that the ban was lifted October 8th, therefore the second week of short interest declines shows that the ban was not necessary to reverse the trend. Yet given the SEC's recent proclivity to change the rules at the drop of a hat, not to mention the significant market decline (and recovery and decline) over the last few weeks, it appears likely that only a few brave traders would take such a position, even if it seems to make sense.

I suspect that someday rationality will re-enter the picture, but it probably will not happen until the short selling cuffs are taken off the invisible hand of the free markets and thrown away for good.

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This article has 19 comments:

  •  
    Oct 25 02:36 PM
    the problem is with NAKED short selling...that is what should be severely penalized...nobody should sell what they dont have or havent properly borrowed...
    Reply | Link to Comment
  •  
    Oct 25 02:57 PM
    Short selling has nothing to do with free markets. That is self justifying nonsense.

    Look at the market as a control system. Unlike traditional control systems, the setpoint isn't known. The purpose is to determine that setpoint at any moment given the state of information. Traditional controllers are characterized by their PID characteristics, proportional, integral, and derivative components. Those are usually defined mathematically, but in simple terms can be thought of this way:
    proportional - when the control variable (in this case the price) moves away from the set point (in this case the spot price) proportional control moves it back towards the setpoint as a ratio of the difference.
    integral - The area under the curve between the control variable and the set point is used to adjust the control variable back to the set point by some fraction over time.
    derivative - the rate of change of the of the control variable is used to adjust the control variable by some fraction of that rate of change.

    What has this got to do with short selling?
    Short selling can be considered a form of derivative control. It makes the changes (in the downward direction) much faster than they would normally be.
    The uptick rule can be considered to be integral control. It adjusts the price in the reverse of the derivative direction in order to prevent overshoot. The amount of the uptick has to be greater than the noise in the control variable. What it needs to do, is make sure the derivative control is not a second order effect. That is, the derivative control isn't growing because of the derivative control feeding back into the amount of derivative control.

    There is also time involved in the system. The response time of the system has to be considered when setting the variables. Otherwise a change will create even more control application before the system has a chance to react. That is, the short selling could move the price a huge amount before the system can respond, before more buyers can move into the market. The uptick rule allows for this, if the uptick is set right. It prevents the short selling from becoming a self fulfilling prophecy. It should probably be something like you can't short a stock unless it has moved up at least a dollar in price or 10% in price.

    The response time for a market depends on the market volume of course. So another way to limit short selling is to make it proportional to the amount of volume in a market or an amount of time that passes in a market. Make a rule that short selling can't comprise more than 10% of market volume in any x time, or short trades can only occur every x seconds. This is more problematic to determine than the uptick rule because it varies with every market.

    In the absence of short selling and uptick rule, the market will still find an equilibrium point, and it will be a reasonable approximation of the true equilibrium point (that can never be known) if the system is stable. The stability in the market is provided by the underlying value of the assets represented by the shares in this case. What differs with short selling and uptick is the movement in the price. With short selling alone, it can get way out of whack with reality because it moves so fast that buyers as a group don't have time to respond. The uptick rule, set properly, prevents this.

    What about the studies showing that uptick had no effect? I haven't read them, but I would guess that the uptick amount was less that the average noise of the market. It has to be above the noise threshold to be effective.

    The firms that failed in the last few months would probably not have failed without short selling, or with short selling and a proper uptick rule. And if they failed, they would definitely have failed over a much longer time frame, giving the market (the sytem) time to respond and adjust.

    So I am arguing that short selling as it is currently constituted is not a market price discovery mechanism, but a market manipulation mechanism.
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  •  
    Oct 25 03:27 PM
    mdmrjsds, you should be writing articles, not posting responses to them!

    This is the most complete understanding the the shorting problem I have ever read.
    Reply | Link to Comment
  •  
    Oct 25 03:57 PM
    Mdmrjsds,
    Ah, why don't you apply your knowledge of control systems to buying? Or is only selling bad? How many people have been stampeded into buying crap for fear the price will rise if they don't? How about banning buying on margin if you wish to ban short selling? Are they not symmetrical?

    I think I agree with regard to naked short selling since this could be an attempt to do the impossible. The market should not be confused with impossible signals though I don't know how to justify this from a libertarian perspective.

    I look forward with interest to what Smarty_Pants might have to say.
    Reply | Link to Comment
  •  
    Oct 25 03:59 PM
    A further thought. Borrowing money via fractional reserve banking in order to buy stocks on margin is equivalent in my mind to naked short selling since the money borrowed doesn't properly exist.
    Reply | Link to Comment
  •  
    Oct 25 04:01 PM
    Think of it as borrowing from a counterfeiter with the stock you buy as collateral. Would that not drive the market into a false buying frenzy?
    Reply | Link to Comment
  •  
    Oct 25 05:44 PM
    banning short selling was the worst thing to do. if it werent banned lehman brothers probably wouldnt have gone bankrupt. because lehman brothers was the weakest of the banks, any long position in lehman brothers would have been liquidated, when short selling was banned, because the investors couldnt hedge with shorts.
    Reply | Link to Comment
  •  
    Oct 25 06:07 PM
    stock directions are not symmetric If a stock goes up it doesn't trigger bank covenants, customer confidence, supplier confidence, credit lines pulled, inability to issue equity, mgmt changes, employees layoffs and morale - going up in price mostly triggers envy. I am not worried about an inexperienced momentum trader getting sucked into buying a stock past it's fundementals. The two movements in house prices and anything economic is simply not symmectric. At the very least each trade should have an active buyer. No games with electronic trading pressure and rumour mongering.
    Reply | Link to Comment
  •  
    Oct 25 06:21 PM
    "If a stock goes up it doesn't trigger bank covenants, customer confidence, supplier confidence, credit lines pulled, inability to issue equity, mgmt changes, employees layoffs and morale - going up in price mostly triggers envy." finmah

    Thanks for those details on how the house of cards get built. I reckon it is ultimately built on the banks ability to create money from thin-air which only benefits the banks and the borrowers and to some extent the depositors of those PARTICULAR banks.
    Reply | Link to Comment
  •  
    Oct 25 09:02 PM
    Naked short selling is destructive since it places no limit to the number of stocks that can be sold. There is no countervailing long side structure to balance this. It is a travesty that this was not banned. Total incompetence.

    Three mode control algorithms are nice if you have a linear system or are operating over a limited range that approximates linearity, and you have a stable operating point. None of these criteria are met by the current equities market.

    As far as fractional reserve banking, NOBODY is forcing anyone to use banks that use this business model. You are perfectly free to bury your money in a cigar box in the back yard if you want. Otherwise, don't tell me how to use my money.

    If fractional reserve banking did not exist some other mechanism would have to be created to supply to economy with credit and money. The mechanics of this may or may not be better than the current system, hard to say which because nobody has tried it.

    Margin availability is stock price neutral because borrowed funds can fund both upside and downside bets. Look at the hedgies for a perfect example of this.
    Reply | Link to Comment
  •  
    Oct 25 10:08 PM
    Agreed and that idiot Cox still has not come out clearly and firmly against naked short selling. Where did they get that guy from? I know, Orange County; lived there.
    Reply | Link to Comment
  •  
    Oct 25 10:46 PM
    "Otherwise, don't tell me how to use my money." otbricki

    Sorry, bub, but it is my money too that you are inflating whether I use a bank or not. I could buy gold and bury it in the ground and I have, so to speak. Now if your bank issued its own currency, I would have no complaint.
    Reply | Link to Comment
  •  
    Oct 25 10:57 PM
    otbricki,

    I did learn from your comment though. Thanks.
    Reply | Link to Comment
  •  
    Oct 25 11:10 PM
    The gov't did not ban put buying. This is the only way to play. Pay no dividends, can only lose as much as you risk. No short squeeze is possible on puts that were bought right.
    Reply | Link to Comment
  •  
    Oct 26 11:00 AM
    up tick rule and no naked shorting is needed.
    Reply | Link to Comment
  •  
    Oct 26 09:50 PM
    The market is a non-linear and chaotic system. Attempting to make sense of it via control systems is wishful thinking at best.

    The markets are a price discovery mechanism. Everyone that participates has their own idea on what the "proper" price for any stock should be. If they can buy below that price they will have 'profited' by trading their money for something they believe is worth more. Those who believe the price is higher than true value will have incentive to sell and 'profit' in that manner.

    As news is discovered regarding a particular stock the individual values will change, which drives the market price to a new level of equilibrium between the sellers and buyers.

    Why does short selling change this equilibrium? In fact it doesn't. If there are enough participants who believe the price is "too low" they will gladly buy the shares which are sold short. If those shares are borrowed or naked really doesn't matter. If someone tries to 'drive' the price far down via naked shorting they will need a huge pile of money to do so, and when that money is gone they will need still more to maintain it.

    The short seller must pay all the dividends for those shares as long as he is still short. The buyer can sell any time he wants to exit his position provided there is an offer (on the NYSE there will always be an offer from the market maker).

    My personal opinion is that naked short selling will have no noticeable impact on the market but to drive it toward a consensus price equilibrium. Others may disagree.

    The claim usually made by the anti-short selling crowd is that short selling somehow puts the business under by artificially driving the share price down.

    How exactly does this mechanism work? I can never figure it out.

    The business sold the shares to the public long ago and already have received the money. The price of their shares has absolutely no impact on sales, costs, or profits. They don't get any of the money that changes hands when shares are traded in the market. How does it impact operations? It doesn't.

    If the business is soundly run and profitable, it won't matter if the share price is "driven" down to 1 cent. The business will continue to operate profitably and anyone with change in their pocket can buy the shares at bargain basement prices and even a modest dividend payment will make them well off.

    If the business if not profitable and is losing money hand over fist, they will eventually fail regardless of how high the price is driven by stock touters (think of the 10 cent mining juniors with no cash and no operating mine, just a deed to a "possible" claim).

    The business performance is independent of the share price.

    The market is simply a way to determine that share price for those who wish to own a piece of the company, for whatever reason. If Bill Gates decides to drive shares for Apple to 1 cent by naked shorting, I'm ready to buy as many shares as I can afford in hopes that my future dividends will support me in luxury. Short away!

    If large numbers of market participants believe that company earnings (and therefore value) will decline sharply in the future, the share price will go down whether anyone is shorting or not. Allowing shorting simply gets the market to an equilibrium faster or earlier, and that's not a bad thing IMHO.
    Reply | Link to Comment
  •  
    Oct 27 11:51 AM
    Smarty_Pants,

    I think you may have missed a tremendous point with respect to short selling. Short selling may not impact the operations of traditional businesses. However, banks and trading companies are hardly traditional businesses. Their lifelines are credit (for good or bad). If you will recall, when Enron went belly up, it wasn't because they kept losing excessive amounts of money via their business operations. They went bankrupt whenever their counterparties refused to trade with them. Sure, Enron in the later stages was making very poor capital investments and sure with the corrupt people at that top running the business they would have gone bankrupt at some point anyways. But this doesn't mitigate the point that IF an institution(s) were able to short the stock of a bank/trading company, buy puts, sell calls, and buy Credit Default Swaps...with enough scale to start a panic in the credit departments of all the target banks counterparties...they would be able to bankrupt the business. Once the credit lines dry up, the banks are finished. Without counterparties willing to trade...what good is a trading company? Now, it is only fair to admit that having a leverage ratio of 10/1 or greater makes little mistakes fatal from a profitability standpoint. Nonetheless, banks/trading companies are not the same thing as APPL or MSFT (incidentally two companies with practically 0 debt outstanding). Credit coupled with counterparties willing to trade is the lifeblood of banking and trading companies. If the share prices of these institutions sinks dramatically it has fatal implications (case in point, Lehman, Bear Sterns, and practically every other bank that has been failing).
    Reply | Link to Comment
  •  
    Oct 27 11:57 AM
    The ironic (&, to me, edifying) thing is that the investment banks were making money hand-over-fist as intermediaries for hedge fund naked shorting, then themselves became victims of the same phenomenon.
    For those of us who aren't billionaires the market needs to be more transparent, simpler & better regulated.
    :-)
    Reply | Link to Comment
  •  
    Oct 27 07:01 PM
    If you want to know about short selling and the power it has given specialists and now designated market makerts you only need to read the SEC Investigations starting in the early 1930's and the subsequent ACTS and rules that were passed attempting to stop specialists demorialization of the market since then. Since specialists have unilateral power to set the price of a stock and that they have the power to compete against you and me, being able to sell short on downticks gives them tremendous control over prices. Fast rising prices bring demand into the market to buy a stock, the specialist sells out his trading, investment and omnibus accounts, and then sells short to meet demand. As he brings the prices down he sells short to the buy orders on his book at lower prices. As the price drops fast and people sell, the specialist uses the short sales in his accounts to cover the demand caused by the selling. The major price movements that you see that go up and down recently in stocks are a factor of the above. As the specialist uses their short sales they then have to buy up the excess demand because not many people are buying and most are selling. Since the specialist objective is buy buy at the very bottom, you see the rallies for the specialist to sell the stock he just bought and to sell short and it continues until the bottom is reached.

    You can read the whole story in the various investigations and the SEC Special Study of 1963 explains it in detail.

    How the heck can the current short sale rule have been allowed when all of the investigations up until now have stated that the heart of the problem is the specialist and their use of the short sale?

    I suppose most of you know that the DOW average decline 25 points today. Add em up if you do not believe me. The DOW divisor of .1255 is make makes the decline appear to be so large. The DOW average should be banned and it is no longer relevant!
    Reply | Link to Comment
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