Given the recent news about bans on short selling, I thought you might be interested in learning some more about what that is and the role that it plays in our financial system. So, this combines and expands on some different comments that I've made explaining it, with a hat tip to gjohnsit.
If you have the money to buy a stock, that's a straightforward deal. If you don't have money and you want to buy, that's pretty intuitive too; you just borrow the money or "buy on margin." Likewise, if you don't have stock and want to sell, then you borrow the stock or "sell short."
So, selling stock short is an inherently leveraged position. There are three kinds of reasons to do that.
One reason to sell a stock short is speculation: you think that the price will be lower in the future than it is now. These speculators are unfairly demonized; sure, their selling creates downward pressure on prices now, but they have to repurchase the stock eventually, which is upward pressure on it later.
If a stock is really getting pounded, that's generally because it isn't worth that much, and banning short sales can't fix that. People won't magically offer a high price for a bad product just because it's in low supply.
In the long run, short sellers help make more deals happen, which is liquidity. They can also cushion the drops by providing extra buying power when prices are low, leading to a short-covering rally, since the inherent risk of being leveraged provides an incentive to be happy with a not-bad price instead of waiting for an extra-good price.
The second reason for selling short is to hedge against a loss in another activity. For example, convertible bonds are debt that can be exchanged for equity, which helps protect the lender against the possibility of default. However, uncertainty (which equals risk) is expensive in general and that goes double for convertible bonds, since a company's stock probably won't be worth much either by the time it starts defaulting on its debt.
That dilemma can be resolved if the buyer knows for sure what price they're going to sell the stock for, which they can set in stone now by actually selling it now (by borrowing shares) instead of waiting until after they've converted the bonds to stock. So, if people can't sell your shares short, then you'll pay much worse rates on your convertible debt, if you can even make a deal happen at all.
The third reason is like the second but pure arbitrage, such as to offset the other half of a two-part trade. For example, it can be combined with buying a call option, which is a derivative that gives the right to purchase a certain amount of underlying stock at a particular price until a certain date.
When you look at the price of a given call option contract compared to the current price of the underlying, that implies a certain expectation of volatility, because you can buy the call option and sell the underlying short at the same time. If the price doesn't change much then you lose (because of the wasted cost of the options), but if it goes down a lot or up a lot then you win without having to know which direction it would go.
There are lots of different funky things you can do. The more people sniffing out those deals, the more ready counterparties there are, which makes things run smoother; taking the above example, if one person is over there wanting to buy underlying stock and someone else is over here wanting to sell call options, the arbitrageur can make a deal happen sooner and at better prices for them than if they had to wait for someone (of the first or second type, speculating or hedging) who only wants to do that one specific deal.
Of course, things are more complicated than that in practice. For example, it's possible to sell stock that you haven't even borrowed yet, called "naked shorting," because it can take a few days for everything to get reconciled.
Think of it like writing a check that you hope won't clear until after you've deposited the money to cover it. Though illegal, some people do it anyway, and as long as you (where "you" means insiders, not actually you you) don't take "too long" (however that's defined) to cough up the shares, then you might be able to get away with it.
So, now that you have that background, here are a couple of interesting articles from last week and a couple from this week.
Hoping a Hail Mary Pass Connects:
Will this latest round of proposals end the crisis? I know the stock market reacted joyously on Friday, but I’m not hopeful. One solution being promoted by the Securities and Exchange Commission — to make life more difficult for short sellers — is a shameful sideshow.
. . .
It’s understandable why people get upset at short sellers in tough times. As President Bush put it Friday, short sellers are "intentionally driving down particular stocks for their own personal gain." But that perception is more myth than fact, and in any case, it’s not the dynamic here. Stocks are falling because companies made huge mistakes that have caused them a heap of trouble. Indeed, in July and August, short interest in financial stocks declined by 20 percent. Why did the stocks continue to go down? Because there were too many sellers and not enough buyers: it’s that confidence thing again. Blaming the shorts is classic blame-the-messenger behavior.
The S.E.C. jihad against short sellers, which includes the banning of short selling on 799 stocks and forcing disclosure of large short positions, is nothing more than playing to the crowd. It is simply appalling that as one firm after another vaporizes — firms, let’s remember, that the S.E.C. was supposed to be regulating — the only thing the agency can think to do is flog the shorts.
Markets Soar, but New Rules Upset Traders:
Many players warned that the government’s sweeping actions might have unintended consequences. The ban on short selling raised questions about how certain parts of the capital markets would function. Companies may have a harder time raising money by selling instruments like convertible bonds, which can be exchanged for shares, because many investors short stocks to hedge against the risks of owning these instruments.
. . .
In the market for options — instruments that give holders the right to buy or sell shares at certain prices — traders reported frantic trading in Chicago and New York. Many big options traders, or market makers, must frequently sell shares short to hedge other trades.
. . .
William J. Brodsky, the chief executive of the nation’s largest options exchange, Chicago Board Options Exchange, lashed out at the S.E.C. "The need for the policy intervention notwithstanding, it is difficult to comprehend the merits of a draconian measure that will result in the sudden and severe removal of liquidity from the marketplace at the same time that the government is taking unprecedented steps to preserve it," he said in a statement.
Some hedge funds frozen by SEC's ban on short selling:
The short-selling ban is taking the "hedge" out of hedge funds.
. . .
With their hands tied on those stocks and the algorithms that do much of their trading running into technical hitches, many quantitative and other "market neutral" hedge funds are drastically reducing trading activity, according to Wall Street Sources.
Short-Sale Ban Wallops Convertible-Bond Market:
The Securities and Exchange Commission's ban on short selling of financial stocks has effectively shut down much of the convertible-bond market, a crucial area of financing for struggling companies.
Convertible securities are essentially bonds that can be exchanged for stock in the future. It's a relatively small market with less than $400 billion in securities outstanding, according to market participants, a fraction of the total for investment-grade bonds. But in times of stress, struggling companies turn to convertibles in order to raise capital when a share price has fallen.