Archive for the ‘trading’ Category

Short selling clamp down

July 16, 2008

After the FSA in the UK has moved to clamp down on short selling during rights issues, after the HBOS drama, the US is looking to follow suit in introducing measures to prevent some short selling that could lead to the collapse of more financial institutions.

Short selling is the practise of borrowing equity and selling it, in the hope that it will drop in value and purchasing it later will yield profit for the short seller. It’s the opposite of long buying, where a buyer buys the stock in the hope that it will appreciate over time. Most of the short selling is done on margins, meaning that the short sellers only pays for a margin of X% (e.g. 10%) without having to finance the whole purchase.

Short selling is not only a legal practise, but it benefits the entire economy as a whole, as it makes the prices more informative. The idea is that value traders who recognize the fundamental value of a stock would short the stock if they see it appreciate above the fundamental value, thus pushing the price towards the fundamental value. So, short selling makes the prices more informative by making the price converge from values greater than fundamental value to the fundamental value of the stock.
The long buy is supposed to do the opposite when the price is below the fundamental value. Then, value traders and arbitrageurs will buy the stock, thus pushing the price towards its fundamental value.
In the end, you always know how much a company is worth by looking at its stock price. At least in theory…

The problem is that fundamental value is not commonly known, but it is calculated by different analysts based on all the available public information. Surprisingly, given the same information, analysts many times reach different conclusions.
The problem is aggravated in periods of market turmoil and economic changes, as the ones we’re experiencing at the moment. In these periods, valuations are extremely difficult as many valuation models need to be recalibrated based on the overall economic conditions. In other words, it’s very difficult to get the fundamental values correctly.
And even if you get the values correctly, values traders might not be able or willing to finance their positions against the market. Especially now, the credit crunch has made the credit more expensive and more difficult to get. But also the sentiment has changed dramatically to doom and gloom and in such a climate, people tend to be overly pessimistic, overreact and some of them stay out of the market. And while they oversell the stocks, it’s very costly and difficult to stand against the market. So you end up with a situation of partial market failure.

In such conditions, the liquidity of the market dries up and it’s much easier for speculators to manipulate the prices. The vast majority of hedge funds are shorting the stocks at the moment. As such, the prices are particularly depressed and the value traders sit and watch before acting, waiting for a clearer picture of what’s happening to the fundamentals.
In such market conditions, you need regulation to prevent short sellers from amplifying the panic and ultimately leading to the collapse of financial institutions which in turn will affect the economy as a whole.

As such, it’s a good idea to impose restrictions on short selling in the short run, but these restrictions will have to be removed when the market starts functioning properly again and I think the FSA, SEC and the Fed will do the right thing. But the only fact that they have to recourse to such measures confirms once again we’re in a bear market that’s here to stay…