Shorting

Summary

It is our contention that all regulation is imperfect, and that markets will find a way to expose truth. Government intervention only helps when it is in the direction of the trend. Bans on short selling, and other interventions designed to slow down or stabilize a market temporarily may work for a period, but in the long run they upset the equilibrium of a market. And that market must rebalance itself.

Overview

Despite the recent ban on certain sticks, traders can and most likely are still shorting them, albeit synthetically. As far as we can tell, these methods are legal; this is not an accusation of wrong doing.

We also do not aim judge the validity of the ban, nor can we assess the merits of a brokerage that allows clients to short stock not held by the firm.

Our goal here is to explain the structure and mechanism for alternate means of placing bearish bets on stocks despite those stocks being restricted from short selling. In this way, we hope to show that imperfect market (de or re)regulation by governments is always undermined by free market forces. Sometimes it happens in the short run, sometimes in the long run, but it always happens.

Sophisticated investors use various methods to short stocks. The tools at their disposal are indexes, futures, options. Some are Exchange based, some are OTC based. All can replicate selling a stock short quite effectively.

A Word about OTC Markets

Individuals with large amounts of capital have the OTC or Cash markets available to them. These are essentially private transactions that take place between a client and his bank. These deals afford the client: discretion, one price liquidity, and access to financial engineers who can create non standardized structures custom made for the client. An example would be an option structure called a collar.

Options Collars as Insurance Policies

A client with a stock position desires to sell it, but for some reason cannot. Using the OTC market he sells a Call option. This removes upside profit potential. He then buys a Put option using the call sale’s proceeds to offset some (or all) of the Put’s cost. This transfers upside potential to downside protection. He “collars” his position. Depending on the options he picks, he can be up to 100% protected. His collar would cost more, but the principle is the same as health or property insurance coverage choices.

Indexes

This one is simple. Bearish a stock? Find an index that has the stock in it. Short that index and then go out and buy every other stock individually except the one you want to short. This of course assumes the index is short-able. It also has some relatively high commissions.

Single Stock Futures

Trading in single stock futures (SSF) as a result of the SEC action was not restricted. People sold stocks short this way. SSFs are governed by the CFTC, not the SEC. this may change as we feel the regulatory agencies will consolidate under one umbrella. But for now, barring an action by the CFTC, SSFs are short-able.

Options

This one can get pretty complicated, as there are many ways to execute. But the effect is simple enough. Here is how it works; buying exchange listed Put options places direct downward pressure on a stock. The deeper in the money, the better the correlation with the actual stock price.

This is because every time you trade an option there is almost always a market-maker on the other side of the transaction. Now factor in that market-makers are exempt from the short selling restriction.

If you are buying a Put, they are most likely selling stock as a hedge. Marketmakers are exempt from the restriction on short sellers.

This is because they must as a function of their own business model sell stock short to hedge directional risk in their trades.

For more information, contact Vincent Lanci at (212) 223-1000.