A Background to Short Selling
There are two dominant ways of making money off of a stock
price change. The most obvious way is to go “long” on the
stock, meaning that the investor believes that a stock is undervalued and the
price is destined to rise in the future. So the investor buys this stock
on the market, waits for the price to rise before selling the stock. The
profit is in the spread.
However, how would an investor make money off of a stock if
he or she believes that a stock is overvalued? The investor can
“short” the stock, by borrowing the stock from a lender (usually a
broker at an investment bank), giving collateral, usually in the form of bonds,
cash or blue-chip stocks, in return. The investor then sells the stock at
the currently assumed “high” price in the market, waits for the price
to drop, repurchases the stock from the market and returns it to the original
lender. The profit is in the spread between the price the stock is sold
for and the price for which it is repurchased (minus the fees paid to the
lender for lending the stock each day). Short selling is an
extremely common investment strategy among hedge funds and represents a
significant portion of prime brokerage business within investment banks.
Within the world of short selling, there are two concepts to
grasp. The first is described above. The second is the concept of
“naked” short selling, a variation of short selling that was made
illegal last fall. Naked short selling is the practice of selling a stock
that you do not yet own and have not yet borrowed. For traders this
process is functional and not overly risky because open trades may be filled
even after the settlement date, when the trade is considered to have
“failed.” Thus, traders have significant time after making a
sale to borrow in the stock and fill the order.
At first this may sound like a reasonable way to create
liquidity; however, many argue that the practice influences supply and demand
dynamics of stock prices by generating artificial supply and, therefore,
diluting stock prices. The SEC enforces the naked short selling ban by
comparing trades flagged as “failed” with a banks/funds inventory at
the time of sale.
Short Selling on Financial Stocks
After the failure of Lehman Brothers in September 2008, the
SEC and the UK’s Financial Services Authority (FSA) temporarily restricted
short-selling on several financial stocks. This was done in response to
assertions that both short selling and naked short selling were too widespread
and influenced the collapse of Lehman. The ban was lifted in October 2008 and
many now regard the ban as unproductive, arguing that it reduced market
liquidity and, thus, exacerbated price swings. This is evidenced by comparing
the smaller market swings in Hong Kong, which enforced strict regulations on
short selling without issuing a ban, with swings in markets like London, where
a full ban was in place.
Bank of America presents a good example of negative
volatility on a financial and systemically important stock caused partly by
short selling. Much of the drop-off occurred after October 2008 when the
short selling ban was lifted (with no uptick rule in place).
Some would argue that short selling (including the practice
of naked short selling) was the key culprit in bringing down Bear Stearns and
Lehman Brothers. In both cases, investors learned of the fallibility of the
financial firm and began shorting. A rapid stock price decline can
incite panic and eliminate the issuer’s access to capital (through the forms of
loans, deposits and trading activities).
Lehman Brothers filed for bankruptcy on September 15, 2008,
just after seeing an enormous spike in short interest. As you can see from this
chart provided by seekingalpha.com, the percentage of Lehman’s Market Cap on
loan (%MCOL) increased from 10% to 18% between September 5 and 11. Utilization
jumped from 35% to 63% in the same time frame.
Short selling was a factor in Lehman’s failure, the
last straw on an edifice built of glue and twigs that appeared to be
sturdy. Shorting speeded the collapse of Lehman’s stock price.
That, in turn, helped spread doubts about Lehman’s ability to survive, and that
doubt led to a run on the bank. The negative feedback loop continued
until the bank’s access to credit disappeared, dooming the institution. Lehman
may have failed anyway, but shorting helped rush it over the cliff.
That said, short selling may not deserve all of the
vilification it has received in recent months. In normal circumstances,
short selling often generates increased trading activity – often making
accurate price discovery easier. Nonetheless, the valuable role of short
selling in stable markets does not preclude the need for regulation. In a
panic, the danger is that unrestricted shorting will drive a stock well below
its reasonable price, with damaging effects all around.
Further market regulation is in the works at the SEC, this
time on the general practice of short selling. The “uptick
rule” has generated impassioned debate among free market theorists, hedge
fund managers, stock issuers and regulators.
The Uptick Rule
In 2007 the SEC suspended the Depression-era regulation on
short selling known as the “uptick rule.” Today, the commission
is debating whether to reinstate a similar rule in order to reduce the kind of
downside volatility that hit stock prices, most notably in financial stocks,
during late 2008. If enacted, the uptick rule would require that a short
sale be made only at a price higher than the last price. (There is some debate
as to whether the “last price” should reference the last sale price
or bid price). Therefore, when an investor enters a short sale order at a
price above the current bid, a short seller ensures that his or her order will
be filled on an “uptick.”
There is a dearth of solid research of the uptick rule’s
effectiveness. This may be due to the fact that comparing today’s
non-uptick rule volatility with the volatility generated while the uptick rule
was in place is a little like listening for the dog that didn’t bark. Who
knows how bad the 1987 stock collapse could have been had the uptick rule not
already been in place? The same could be said of the dot com bust.
Arguably, no downturn is the same – they often affect different industries
differently. The most recent, marked by a total loss of confidence in an
over-leveraged financial industry, is most likened to the Great Depression, in
response to which the uptick rule was first put in place, 1934.
The Case for the Prosecution
Some deny that short selling exacerbated the financial
crisis at all. TFS Capital portfolio manager Eric Newman was quoted
in the Wall Street Journal Online, “I think [the uptick rule is] a
feel-good thing so Congress and everybody involved can act like they’re doing
something concrete…I don’t think the short-sellers have made it any
worse.”
A more common argument is presented by Herb Greenberg in his
blog post “No
Uptick Rule: Convenient Scapegoat?” He argues, “If they were
to reinstate the uptick rule, shouldn’t there be a downtick rule?
Wouldn’t it help eliminate the stock melt-ups and bubbles?” This
case is usually posited by market stalwarts and hedge fund managers. The idea
is that the uptick rule represents an inflationary bias – volatility is okay on
the way up, but not on the way down. And the result would be artificially
high stock prices.
But can the two sides of the market really be compared and
equated?
There is an innate pathology of markets that dissimulates
the up and down sides. Therefore, the uptick rule actually functions to liken
the two.
In Defense of the Uptick Rule
If enacted, the uptick rule will serve to create bumps in
stock market slides, thereby making the shape of declining stock prices more
similar to that of rising prices. The uptick rule will help, in some small
measure (the extent of which will never be truly known), bridge the gap between
the way stock prices tend to rise and fall.
Specifically, the uptick rule will help counteract the
extreme sell off patterns occurring during times of stock market panic and the
effects of hedge funds, which often jump on each others’ shorting bandwagons
when profitable.
Is the upside as volatile as the downside? When one
looks at the closing price of the S&P 500 over the last 25 years, both
daily and weekly, it is significantly more likely for there to be an extreme
percentage change in closing price on the negative side as compared to the
positive. The graphs below demonstrate this pattern. An extreme
daily percentage change of greater than 5% occurred one quarter more often on
the downside than on the upside. Weekly, a percentage change of greater than
10% occurred nearly twice as often on the downside as it did on the upside.
Short selling is dominated by institutions (hedge funds,
investment banks and money managers). Individual investors, who trade less
often and in a more stable profile, are often focused on long-side
investing. Therefore, short selling attracts the institutional investors
that are more apt to ride the market rather than trade solely on
well-researched belief that a stock is overvalued.
Intensive short selling has not only affected important
financial stocks. In fact, Alcoa Inc., a major aluminum miner and
manufacturer that is subject to London Metals Exchange aluminum price
forecasts, presents a prime example of the fact that positive volatility is
rarely as intense as negative volatility.
In 2007 Alcoa’s stock price shot up to $47 after hovering
around $30 over the previous few years. The sudden boom was caused by rumors of
a takeover by Rio Tinto. The acquisition was not realized, as Rio chose to
take-over Alcan instead; as a result, Alcoa’s stock price dropped more than
$10. In contrast, between September 2008 and February 2009 Alcoa lost a
whopping $27. The cause was a pessimistic LME outlook for aluminum price
coupled with a decline in projected aluminum consumption during the commencing
recession.
During boom times of optimistic LME outlook, Alcoa’s rapid
stock price increases were usually less than half the negative price change
that occurred in late 2008. Alcoa’s share price history exemplifies the
fact that upside volatility is usually not as extreme as downside volatility.
The Alcoa example also shows the piggy-backing effect of
short sellers after a pessimistic report. In January 2009, the value of
Alcoa rose somewhat, most likely because long-term focused individual investors
saw the post-recession potential in Alcoa, not to mention that it had an
extremely low P/E ratio of 5.75. Such a P/E ratio gives credence to the
idea that Alcoa was over-shorted. Therefore, one potential benefit of the
uptick rule is that it could reduce this problem of overshooting on the downside.
The uptick rule may not completely even the playing field
between negative and positive volatility, but it is a helpful mechanism to
smooth the downside.
As Jim Cramer, an ex-hedge fund guru, prophesized in 2005:
Without the uptick rule “hedge funds can sell
shares short just like they sell them long: with reckless abandon…I know I
would have done it because I know I can process this stuff [shorts] faster than
the longs. You could see some real nasty things happen to companies that mess
up. You will see them banged down harder and faster than you would ever
believe… This rule is enough to make me want to get back into the hedge fund
game.”
Emily Gallagher was an analyst on the trading floor at
Deutsche Bank – London in the stock borrow/loan department.
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