With all the trouble in the overseas markets right now, one of the ideas being bounced around is the idea of banning short selling. When we here in the US decided to try the same thing, we found out two facts about it that we did not know prior. First, individual investors loved the idea. They thought it would be the answer to the problem of a declining market. The second thing we learned, a vastly more important lesson, is that banning short selling does not work! In addition, it does a disservice to individual investors like you and me by putting us at further risk!
Let me explain mechanically why banning short selling does not work. It does not prevent market sell-offs or crashes! You see, your average, everyday investor is not the one selling stocks short. It is the professional traders and the big institutions. These two groups are the ones who are responsible for almost all the short selling in the market. Now these two groups of professionals know the business pretty well and have found a way around the short selling rule. Instead of selling the stock short, they will just buy puts!
They will buy puts from the market makers on the floor of the exchange. See, what they know that you don’t is that the market makers have a short stock exemption. That means they are allowed to hold short stock positions and they are allowed to short stock on a downtick. This is because they have a fiduciary responsibility to provide liquidity. For instance, say you wanted to buy some puts and the market makers sell them to you. You would become long the puts and the market makers would become short the puts. Now, the market makers would have unlimited downside exposure. The market makers need to hedge their position and often they have to do it by using the stock.
In order to facilitate the customer order, the market makers have to be able to sell the stock short! If they do not have the ability to sell the stock short, the market makers would not be able to provide the type of liquidity that the US markets call for and need. Knowing this, the SEC provided the market makers with an exemption so that they can always provide the type of liquidity that separates the US markets from all the others.
What I am trying to point out is that the institutions have figured out how to side step this rule. Stock is still getting shorted, it is just not the institutions doing it……it is the market makers doing it for the institutions. All the rule has done is to make shorting the stock a two step process instead of one step. Either way, the stock is still getting shorted….the rule has NO effect! But, there is collateral damage. With the institutions and professional traders rushing out to buy puts, the price of puts will go up via an increase in volatility. This makes it much more expensive and a lot more difficult for individual investors like us to purchase protection in worrisome times. In essence, the only effect of the short selling ban is the increase in the price of our insurance.
0 Responses to “Selling us Short”