All Commentary
Tuesday, January 5, 2010

The Long and Short of Short Selling

Short selling is a little-understood, much-maligned tactic by which traders can profit from their belief that a company’s stock is overvalued.

Following the financial problems of the last two years, short selling has come under fire, with new or revived regulations proposed to curb the practice. It is unpatriotic, destructive, and destabilizing, say the critics. Such complaints are nothing new. President Hoover blamed short sellers for the continuing market declines of 1931 and 1932, threatening regulation or even outright prohibition. “Individuals who use the facilities of the [stock] Exchange for such purposes are not contributing to the recovery of the United States,” he grumbled.

Defenders say short sellers add liquidity to markets. When short sellers are present, buyers encounter a more liquid market because they face a larger pool of sellers than they would otherwise. More sellers—more liquidity—means more predictable prices and smoother price changes. Shorts can put a damper on runaway enthusiasm, and when they are right, they can hasten the demise of failed businesses.

The mechanics of short selling are simple. You borrow stock and sell it, hoping its market price will decline so you can repay your loan with stock that you buy cheaply. In the meantime, you are said to be “short” that stock, the opposite of the situation of someone who owns the shares and is “long.” For widely traded stocks, brokers can easily find shares to borrow, either from their own inventory or from customers who have agreed to make their shares available. For thinly traded stocks it may be difficult or impossible to find shares to borrow. The short seller must pay the lender the amount of any dividends that the stock pays while he is short. And most brokers require cash on deposit to cover the obligation to buy the stock later on.

Most short sellers simply think a stock is overpriced and hope to profit from a decline. But sometimes short sales are used as part of a hedging program. If you want to “hedge your bets” you can short a stock to offset possible losses in a related stock that you own. For example, if you aren’t sure where the oil industry as a whole is going but you think Chevron is overpriced relative to Exxon Mobil, you can buy XOM and sell CVX short. Or you may have shares of your employer’s stock coming to you as part of your year-end bonus but you fear a price drop before then. You can sell short and then cover your position with the shares you receive. (Hedge funds, incidentally, were originally organized to engage in hedging, but have since expanded into all sorts of exotic trading strategies.)

Since there is no limit on how high a stock price can go, short sellers who are not hedging expose themselves to unlimited potential loss. Amateur investors should be very careful about selling short and should use stop orders to exit their position if the market goes against them.

Failure is an essential feature of free markets. Companies that suffer losses must be allowed to fail so that scarce capital can be redeployed into lines of business that better serve consumers. Short sellers, when they are right, hasten the necessary decline of the stock of a faltering company. In extreme cases, short sales can predict liquidation or bankruptcy. In other cases the stock of a generally sound company may have been driven to unsustainable heights by bandwagon psychology, and short sellers can help deflate those spikes and hasten a return to more realistic levels.

But the message that the short seller brings is not always popular. We don’t like to hear bad news. We may think there’s something unseemly about speculators profiting from other people’s troubles. Executives of companies whose stock is being shorted can be particularly vocal about blaming speculators for beating up their company shares when in fact their own management blunders are at fault. Almost since the beginning of organized stock trading, short sellers have been suspected of distorting markets, destroying good companies, and reaping unjust profits.

Abusive Short Sales?

Can speculators start a run on a stock using massive short selling? Dumping large blocks of stock could cause a price drop that would frighten many holders into selling out, driving the stock still lower—a waterfall decline. Then at just the right moment, the shorts could cover their positions (buy shares to repay their stock loans), taking a big profit. Their profit would come at the expense of other shareholders, with no fundamental developments accompanying the price swings.

Such maneuvers are possible in theory but quite difficult to pull off successfully. You have to find shares to borrow, and lots of them, if you’re going to have a noticeable impact on the share price. Then you have to get the timing just right. If you don’t and the share price rebounds before you can get out, you’re left holding the bag, with unlimited potential losses as the stock rises. If you are conspiring with others, there is always the danger that one of your group will break ranks and grab profits ahead of the others. Manipulation, therefore, is much easier said than done.

“Naked short selling” has come under scrutiny recently and has been the subject of an increasing number of lawsuits. One plaintiff’s lawyer calls the practice “the largest commercial fraud in U.S. history, involving hundreds of billions of dollars.” In a naked short sale, the seller has not borrowed the shares that he is obligated to deliver, but seems to be making them up out of thin air. Clearly this is fraudulent behavior. Clearly someone has been cheated.

Not necessarily. Sellers, short or not, are given three business days to deliver the shares they have sold. Short sellers are required to have borrowed the shares or have good reason to expect to find them by the settlement date. If that day arrives and the stock has not been delivered, a “failure to deliver” event is recorded. To see what happens next, we need to understand a little of how stocks are held and traded these days.

Stock trading has evolved into a highly efficient business. Customers can enter orders online and see the results in just seconds. Commission rates are low, often under $10, and problems are extremely rare. This happy situation has been made possible in part by the elimination of paper stock certificates. When you buy stock in today’s market, you actually acquire an entitlement to shares that are kept in the possession of an organization called the Depository Trust Co. (DTC). When you sell your stock (or, strictly speaking, when you sell your entitlement), another organization, the National Securities Clearing Corp. (NSCC), issues an order to the DTC to record the new entitlement. The physical securities are not touched. Most brokers are members of the NSCC and conduct virtually all their trading by electronic transmission of orders to transfer entitlements.

Failures to deliver are rare, and the DTC and the NSCC have procedures in place to handle them when they do occur. First, the seller does not receive funds until the shares are delivered. Likewise, the buyer does not relinquish funds until the shares are delivered. If the settlement date passes and the seller has not delivered, the buyer can send a “buy-in” order to the NSCC. The seller gets two more days to deliver the shares, and after that if there has still been no delivery, the NSCC will purchase the shares and charge the account of the member who failed to deliver.

In this situation the only difference is who acts as the effective lender of the security. While this is certainly not the normal course of events, it is hard to see how the economic effect on the market as a whole is any different from the effect of a short sale completed in the normal way.

Thus naked short selling does not appear to be a major problem, nor does it have the dire consequences one might expect.

Regulation of Short Selling

The Securities and Exchange Commission (SEC) regulates stock trading in the United States. Regulation of short sales began in 1938, and the current “Regulation SHO” was adopted in 2005. Short sales are explicitly permitted except, according to an SEC commentary, when “effected to manipulate the price of a stock.” The commentary does not state how the intent of a seller is to be determined. Presumably, an expression of satisfaction when the stock falls is not enough. Nor, one hopes, is knowledge that any sale will put at least marginal downward pressure on the price. But this is just the sort of fuzzy, non-objective law that opens the door to abusive prosecution.

The SEC commentary on regulation specifically addresses failures to deliver and naked short selling. Interestingly, it declares that naked short selling is not always a bad thing, but rather, in certain circumstances, it “contributes to market liquidity.” It cites as an example a market maker (a specialist or a broker/dealer) whose job is to offer to buy and sell a particular stock continuously even when there are no other buyers or sellers. To meet a sudden surge in buying, a market maker may sell short without having first found shares to borrow. The public benefits from a smoother market, and there is almost no risk that the market maker will be unable to net out his position in a reasonable time.

The SEC has been fielding a growing volume of complaints alleging possible market manipulation via short sales—about five thousand between January 1, 2007, and June 30, 2008. Of these, just 123 were forwarded for investigation. None were pursued. The SEC staff has downplayed the importance of naked short-selling abuses.

This has not deterred politicians from gunning for short sellers. Leading the charge is a group of six senators led by Edward Kaufman (D-Del.). So, notwithstanding its relatively benign view of short selling, even some forms of naked short selling, the SEC has decided to propose rule changes to curb short selling. Reinstatement of the “uptick rule” is one proposal, and there might also be “circuit breaker” provisions to further inhibit waterfall declines. The SEC’s recent proposal to reinstate the rule was met with mainly negative reactions from people in the securities business, and at this writing no decision has been made.

From 1938 to 2007 an uptick rule was in effect. At any given moment, a stock has “ticked up” if its last price was higher than the previous price. When a stock was declining, short sales were forbidden until an uptick occurred. This was supposed to help curb runaway declines.

A major change in trading took place a few years ago when the time-honored practice of quoting prices in dollars and eighths of a dollar (sometimes sixteenths) was abandoned in favor of decimal quotes. The change was welcomed by just about everyone, especially those who had to do arithmetic with prices. The economic importance of the change was that stocks now move in one-penny increments rather than eighths (12.5 cents). An uptick rule in the one-penny environment has far less effect than under the old fractional regime simply because there are smaller and more frequent price changes, so that the tick changes direction more frequently. But reinstating the rule would let politicians take credit for pressuring the SEC into “doing something” about the nasty short sellers. And they will probably cause little damage to the markets in the process.

Circuit-breaker rules were put into effect after the crash of 1987. In case of a severe selloff, trading on the New York Stock Exchange, as measured by the Dow Jones Industrial Average, can be interrupted or halted, depending on the time of day and the magnitude of the decline. The proposed new rule would extend this idea to individual stocks, interrupting or halting short sales of stocks that have experienced rapid declines. This rule may or may not make much difference depending on how the parameters are selected. It could give an unfair advantage to sellers of a stock who already own it. With competing short sellers temporarily locked out of the market ordinary sellers, still allowed to sell, could enjoy a price advantage. It might also be difficult for market makers to distinguish ordinary sell orders from short sales.

In the long run stock prices are determined by fundamentals. In the short run all sorts of influences drive stock prices: exuberance, despair, rumors. Those who choose to engage in short-term trading should understand this and be prepared for volatility. Restraints on honest short selling can only hinder the recognition of failing companies and stymie the efforts of hedgers to reduce their risk.

  • Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.