Short Selling - An Option Trader's Perspective
In turbulent markets, short sellers are among the most profitable, and hated of the many creatures who inhabit Wall Street. Many retail investors consider short sellers "thieves" and they have even been described as, "The guy who takes out a life insurance policy on his neighbor, and as soon as it takes effect, runs him over." Both these perspectives, and most importantly, the measures under consideration to "reign in" the short seller are both wrong and wrong-headed, and market-savvy traders know it. Short sellers provide a several vital mechanisms for healthy, functioning markets. The "shorts" dampen, not increase volatility. They provide liquidity, and the shorts also preserve capital. First, we should understand what short selling is and what short sellers do.
[Update] They did it. They banned short-selling 799 financials, with General Electric (GE), a "financial in drag" considered for addition to the list. When the next one blows up because fo fundamentals, they won't be able to blame the "shorts." And the shorts won't be there to preserve the lost capital. They have lit the fuse on a bomb, and there is no way to do the calculations for burn-time or blast radius.
Investing 101
Publicly owned companies, by definition, have stock, or ownership, certificates that are traded daily on the stock markets like the NASDAQ or New York Stock Exchange. Each "share" provides it owner with a fractional ownership of the company, and entitles the owner to a portion of any dividend paid, and in most cases, voting rights via a company proxy with each share constituting one vote. The value of each share is determined by the market participants who bid to buy, or offer to sell their shares. An investor who believes that a company's stock is undervalued at the current market price may offer to buy shares, whereas an investor who perceives that stock to be overvalued might sell those shares.
A short seller is an investor who perceives a company as overvalued, but he does not own the stock. The short seller will "open a short position" by borrowing the shares from someone who does own them. The broker is responsible for locating shares to borrow and placing them in the account of the short seller. Then the shares are sold according to the terms of the order to sell them. The short seller is now "short" shares. At some point in time, the short seller must buy those shares back and return them to their rightful owner. He hopes to do this after the price of the shares has declined to a point where he can repurchase them for less than he sold them for and keep the difference in price. It works like this:
Bob Trader thinks that Yoyodyne is overvalued. He does not own YOYO but he believes that the rest of the market will soon reach the same conclusion. He places an order to sell 1000 shares of YOYO at $50 per share. The broker, knowing that the stock is "easy to borrow" usually executes the trade immediately and then locates stock for delivery at the settlement date. The settlement date for stock transactions is 3 days, per Securities and Exchange Commission rules. The shares must be delivered, or the short seller is in violation and will receive a "margin call" and must purchase sufficient shares at the current market price and deliver shares to the buyer immediately. In this extremely unusual scenario, fines and penalties are also assessed to both the broker and the short seller.
In opening this "short position" the short seller exposes himself to risks that the "long", or stock buyer, does not have. In theory, a stock can only go to zero (though many traders have wished that a stock could go lower, and others have felt like they have!). This means that in our hypothetical trade, the most that Bob can possibly make on the trade is $50 (less transaction costs, margin interest and dividend expenses.) However, in theory, a stock could go up to infinity. In reality, this means that the short seller has undefined risk if he is wrong and the stock continues to rise. Additionally, the short seller must pay margin interest on the amount that the shares are worth, and is responsible for paying any dividends to the rightful owner of the stock. If Bob is right and YOYO drops to $40 per share, he will "cover his short" by buying the shares back from the market at $40 and returning them to their rightful owner. He sold for $50 and bought for $40, and is happy to pocket $10000 in profit ($10 per share x 1000 shares), less expenses. Of course, the person who lent the shares and the person who bought them are probably not so happy, but that is the market.
On the other hand, if Bob is wrong and the shares rise in value, Bob is losing more and more money with each tick up. Additionally, his interest expense is also rising, and so is his margin requirement. YOYO rises to a point that exceeds his available margin, Bob will get a "margin call" and must either deposit sufficient cash or close the position at a loss on that trading day. Margin requirements vary by broker, but Federal margin requirements are fixed by law. If the stock makes an enormous move up, Bob may get a "Federal call." If the Federal call cannot be met, a "forced liquidation" occurs. In this scenario, the position is closed at the market and any other securities held are sold at the market until the margin requirement is met. In this case, Bob is said to be "puking stocks" and is not a happy camper.
This begs the question, "Why would anyone lend shares to be shorted?" If the owner of shares is still "bullish" on the stock, he may see this as no big deal, the short is going to be "squeezed" by the rising price and have to return the shares anyway. Aother trader may look at this and wonder, "What does he know that I don't?" The owner may then decide not to lend the shares at all, but to sell them himself. Of course, he'll kick himself if the stock goes up, and he misses that additional profit. A truly savvy trader will spot an opportunity here and buy two "puts" for each 100 shares lent out. This creates a position called a "synthetic straddle" and will profit regardless of whether the stock moves up or down. Some traders actually open a position by shorting stock and simultaneously buying two "call options" for each 100 shares short. This also creates a "synthetic straddle" which profits from a move in either direction. It is sometimes used by traders who want to capture small moves both up and down. This is known to options traders as "gamma scalping."
Short Selling and it's Effects on Markets
Short sellers provide several vital services to healthy markets. Short selling:
• Provides liquidity.
• Reduces volatility
• Preserves capital
• Is crucial to the role of the Market Maker
Liquidity
Short sellers provide liquidity in markets by selling when everyone else is buying, and vice-versa. When YOYO is screaming higher on hype, the short seller sees through the hype and sells into the rally when everyone else is buying. This dampens the volatility by slowing the rise in price. It also protects buyers by limiting the rise to something reasonable and not based upon hysteria. This is true because of the unusual risks of selling short; The short seller has to do much more due diligence in order to avoid getting "squeezed" in a rising stock. The short seller also slows the decline of a falling stock because he MUST return the shares sometime. He may have no idea how much farther the shares will fall, and will be buying them back on the way down. Those crucial buy-orders give the longs their exit before they are decimated by a falling stock. The worst feeling in the world for any investor is to find himself in a position that he cannot exit because there are no buyers.
Volatility
The net effect of selling the hype and buying the panic is that both extremes are reduced. This actually lowers volatility by slowing the speed at which something goes up, and at which it comes down. Since the market tends to "overshoot" in both directions, this prevents stocks from becoming absurdly overvalued on the upside, and "pounded into the ground" on the downside. This lowering of volatility is beneficial to all market participants because it makes markets orderly.
Preservation of Capital
When a stock is falling, someone is losing money. For them, it just evaporates. In reality, it is the short seller who profits. The capital used to purchase a stock is transferred to the short seller when he "buys to cover his shorts." If there were no short positions to cover, a falling stock would quite literally destroy the money used to buy the stock. For example: Without short-sellers, frenzied buyers could run YOYO up to a preposterously high price. When people who got in near the bottom see their ludicrous profits, they overwhelm the hysterical demand with supply, selling to capture the profit. Then YOYO reverses and falls as abruptly as it rose. But there is nobody buying any more. Everyone is a seller. The two most frightening words in any market are "NO BIDS." Since something is only worth what someone will pay for it, when there are no bids, the price is zero. If YOYO is bid up to $500 per share, and then someone starts selling, YOYO drops fast. This causes panic and forces more people to sell, and since there is no demand, the price drop accelerates. YOYO crashes harder. Without someone receiving a profit, the capital invested is destroyed. It no longer exists. Money literally goes back to where it came from: Nowhere. (This touches on the role of the Federal Reserve in our "fractional reserve" banking system, our "fiat money" system and how money is created . . . but that's another blog unto itself. For a better explanation than I can give, I refer the reader to G. Edward Griffin's "The Creature from Jekyll Island" )
The short seller is a blessing to all since he prevents YOYO from being bid to ridiculous prices in market hysteria, and prevents it from falling so far, and so fast that nobody can get out, and by profiting from the trade, he preserves the capital invested and can re-invest in the market. Without him, real wealth simply vanishes.
The Market Maker
Whenever an investor places an order to buy a security, his order goes to a market. At that market, members and member firms, or Market Makers try to match buy orders with sell orders. When they find a match, a trade is done, and the Market Maker makes a small profit on the trade by capturing the "bid and ask spread", or as it is known, "the scalp." In return for the privilege of scalping every trade, the Market Maker is required to "make a liquid market" by taking the opposite side of a trade when no matching orders can be found to pair into a buy and a sell. This does not mean that he must take a loss on the trade. If such a situation arises, the Market Maker will first put on the opposite trade with a hedge and then fill your order. If you are buying YOYO, and there are no other sellers to match your order with, the Market Maker must sell you the shares of YOYO that he does not have. He is now "short" YOYO. If you are right, he is in a losing trade. So he hedges by buying "call" options to protect his position. In the case of an index, he may use a futures contract. In any case, part of your "bid/ask spread" is covering the Market Maker's transaction costs. As you can see, without the Market Maker's ability to short stock, it could be very difficult to make a market.
Those Evil Short-Sellers!
Today we learn that short-sellers are being blamed for all of the market's ills from self-destructing banks to excessive volatility to wealth destruction. Nothing could be farther from the truth. Now the Federal Reserve, the Treasury Department and the Securities Exchange Commission are going to put a stop to those evil short-sellers! We hear that they are contemplating banning short selling altogether. This is simultaneously stupid and dangerous. By removing the crucial effects of short selling, the markets will become more volatile, not less. Markets will be less liquid, not more. And when the next shoe drops, the losses will be real for everyone because that invested capital is destroyed. All of this sets the stage for the greatest market collapse in the modern history.
Those Stupid Politicians
Make no mistake, this is a political ploy to try to prevent the inevitable and both parties are in on it. The fact is the financial system "got drunk" and not only has a hangover, it is violently ill. In fact, the drunk was so bad, it has resulted in alcohol poisoning. The problem is not short sellers. The problem is DEBT and LEVERAGE. When you borrow money to lend, and then borrow money to spend, and then borrow money to insure someone else's borrowed money (which they lent out), as soon as someone defaults, the whole house of cards comes down. Now everyone wants a put. And here's the painful truth: We have to give it to them because we need them more than they need us. We, The People, will end up paying for the excesses of the banking industry, saving them from themselves, while those who caused the mess in the first place keep their riches. The deepest pockets in the country are being bailed out, once again, by the shallowest. The seeds of this disaster were sown in the idea that "Deficits don't matter" and that you can "spend your way to prosperity" and you can borrow infinitely to do it. Years ago, a blogger at DailyKos known as "BondDad" warned us that the Bush economy was nothing more than Asset Inflation, and that there was no real wealth being created. You are now witnessing the unwind of "Reaganomics." Just as we found the seeds of Enron, Tyco, WorldCom and Arthur Andersen in the GOP's "Contract for America", we find the match that lit the fuse on the mortgage time-bomb in the 2006 Bankruptcy Reform Act. Shame on YOU, Dianne Feinstein and Joe Biden, for not stopping this when you had the chance! This gem of legislation, brought to you by the Republicans, makes bankruptcy for an individual nearly impossible. With this in mind, lenders now felt themselves to be in a "Risk-Free Trade" by extending credit to anyone who could fog a mirror. The financial system thought they had the Ultimate Put, and that risk no longer existed: The Law says they have to pay! It ignored one other law, more fundamental, more immutable: You can't get blood from a stone.
There is no mercy in the markets, only justice. If we really believe in free markets, if we really are Capitalists, then we must let the market work it's justice. There really is only one cure for our ailing financial system: Time and price. Those who put their firms and our prosperity in jeopardy must suffer the consequences, as painful as that may be for all of us. To do otherwise is to abandon Capitalism. After all, is it really Capitalism if there is no risk? The ceaseless creativity of Ben Bernanke, Hank Paulson and Christopher Cox in inventing new ways to transfer risk from those who should be wearing it to you and me is astonishing.
We have hard times coming. Be sure to thank the Republicans for the hardships at the ballot box. Spare no vitriol for the Democrats either. They're in it up to their necks in this, too.