I can’t quite figure out why the government and people in general are eager to enact new rules like the uptick rule and individual stock circuit breakers to combat short-selling as if it’s an evil thing.
I do understand how aggressive short selling can disrupt a situation where leverage is used or other forced actions are required based on price action and valuation changes. I’d say these situations need to be dealt with fundamentally and not by trying to protect something which is obviously unstable by limiting the ability of the markets to correct it.
Here are the reasons that this line of attack seems unreasonable:
1. Short sellers are fairly small in relation to markets overall. While they can be felt in focused areas, funds available for short-selling are small in relation to pool of assets that can make long investments. Short selling can make a real impact when it is focused and especially where markets are thin. But they are far too small to be labeled as being a major part of the problem. They may have been a catalyst to accelerate or cause some bad structures to tumble but they are not strong enough in and of themselves to be a primary factor.
2. There are a variety of reasons to sell short, most of them are neutral or positive, not evil. For example we use short positions as a way to lessen our market and sector risk against our long portfolio. It stabilizes our overall equity value and allows us to further enhance our returns based on good stock selection. For example one would want a long postion in Apple based on their strong fundamentals but a year ago the stock was hovering between $160 and $180. So even though a long position in AAPL is “correct” from a research standpoint (at least ours) the valuation and market risk means that today you are down materially if you didn’t take some risk-limiting or buffering action. Most efficient asset allocations would include short selling or short positions as part of an overall strategy.
3. Options and derivatives are another way to have a short position. One can sell calls, buy puts or enter elaborate combinations of contracts to effectively establish a “synthetic short” anyway. If you’re large enough, brokers like Goldman Sachs or JP Morgan can even create a special contract for you that isn’t even traded in the public market. So focusing on just one method of being short (shorting selling the stock) seems odd.
4. What about rules on the other side of the ledger? What about funds that buy stocks, especially thin ones, at the end of the quarter to enhance quarterly returns? What about investors and sometimes managements that target a stock with a large short position and intentionally try and “squeeze the shorts” to goose the price of a stock? There are just as many abuses by unscrupulous types on the long side as the short side. Spreading a false positive rumor can be just as effective (and illegal) as spreading a negative one and being positioned to make profits from the likely market reaction.
There do appear to be areas like fail to deliver and others that make sense to crack down on. Targeting a type of investment seems just plain wrong if a market is to function properly. Short sellers contributed to the drop in PALM to $1.20 just a few short months ago. We were only too pleased to buy stock there thank you very much. That’s what makes a market.
Speculators and investors long or short are putting their capital at risk. Their rewards and punishments are meted out by the market. Bad decisions and management brings one to ruin, good decisions backed up by strong research, valuation analysis and risk management make you rich. Hasn’t all this already been covered already somewhere like “Markets & Investing 101?”
Not happy to be up on the soapbox so I’ll get off now. 
[Disclosure: Research 2.0 maintains a small, actively managed portfolio of technology stocks to put our ongoing research conclusions for validation. Risk management includes a dynamic adjustment of position sizes and the use of short positions and options.]
Comments on this entry are closed.