Types of short selling
There are two types of short-selling. Generally speaking, a typical short sale involves the sale of a stock which, although you do not own, you either borrow (usually from your brokerage firm) or enter into a good faith arrangement to borrow. The stock a short seller borrows is then required to be delivered to the buyer’s clearing firm by the close of business on the settlement date, which is three days after the trade date, universally known in the securities industry as “T+3”.
In a naked short sale (the second type of short sale), the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer by T+3. As a result, the short seller fails to deliver the securities to the buyer when delivery is due, which is known as a “failure to deliver” or a “fail.” In theory, drastic cases of naked shorting can create a virtually unlimited quantity of shares (because the shares are never borrowed or delivered), and obviously, a market predicated upon supply and demand can suffer grave negative implications in such a scenario. “Bad actors” who engage in naked short selling may use the additional leverage (of not borrowing or delivering the security) to artificially depress the price of a security, which can coincide with other negative implications, such as depriving purchasers of voting rights for example.
How rampant are the abuses by “bad actors”?
While there is no question that short selling has been abused by bad actors, I respectfully disagree with the notion that short selling is used “mostly as a vehicle for abuse.” In fact, my understanding is that the vast majority of short sales are legal. In my opinion, the primary concern in connection with short selling arises in the context of abusive naked short selling, not short sales in which shares are legitimately borrowed and timely delivered. That said, I believe short selling enhances liquidity and pricing efficiency in the markets.
Advantages and facts of short selling
1- Short Sellers prevent stocks from getting overpriced.
2- When companies fight short sellers, short sellers are usually vindicated.
3- Companies that fight with short sellers tend to underperform the market.
4- Volume of shorting has increased dramatically mostly due to the activity of hedge funds.
5- Shorting allows options market makers to hedge their options market-making positions and therefore maintain strong options liquidity.
What is the SEC doing about naked short selling?
The SEC has recently implemented regulations which will significantly curtail abusive naked short selling. For example, effective October 17, 2008, the SEC adopted Rule 10b-21, which is a naked short selling antifraud rule that expressly targets fraudulent short selling transactions. On July 31, 2009 (and most significantly in my opinion), the SEC adopted Rule 204 to Regulation SHO, which, notwithstanding limited exceptions, now requires mandatory close-outs on T+4 for fails resulting from short sales (the close out requirements were much more lenient before Rule 204).
In addition, on February 24, 2010, the SEC also adopted an alternative uptick rule (Rule 201) as part of the continuing efforts to curtail abusive shorting. This replaced Rule 10a-1, better known as the “uptick rule”, which was repealed in 2007. The new alternative uptick rule involves circuit breakers and is triggered by a 10% decline in a security. While these new regulations will not completely eliminate abuse in the short selling arena, I believe they will significantly curtail the same.
Short interest theory:
There are several technical market theories (to be discussed in more detail in my upcoming book) that profess to predict future movement of the equity being analyzed. One such theory is called the short interest theory. This theory states that a larger short interest is the predecessor of an increase in the price of a stock. Since a short sale is the sale of a stock not owned by the seller, an investor who sells a security short borrows that security from a broker and then sells the borrowed security without having ever actually owned the same. The short-seller must eventually buy the security back, or “close” the open short position. This is buying waiting to happen. Short interest is the number of shares sold short that have yet to be covered. As noted, shares ultimately will need to be purchased after they are sold short to cover the short position. Some short sellers who fear a decline in the price of a short security may cover their positions sooner than anticipated or suddenly as bullish news regarding the underlying security is perceived. This is called a short squeeze. A rising short interest is considered a bullish indicator.
Short percentage float information can be found at the following site:
Type in ticker and look for “key statistics”.
Anything over 10% is considered high and over 20% extremely high and therefore quite bullish.
There are many investors who believe the current regulations do not go far enough, and that other/additional restrictions should be enacted. It would be impossible for me (or anyone for that matter) to definitively opine whether this point of view, or the alternative, is right or wrong, or whether the current state of the law will have its intended effect in full. I certainly believe the regulations will, particularly in light of Rule 204, which focuses on the clearance and settlement process where, in my opinion, abusive short selling is most likely to appear. With appropriate regulations in place, the good appears to outweigh the bad.
Egypt and our Premium Report:
Stocks suffered their largest losses in months on Friday as a result of the uncertainty created by the chaos in Egypt. The globalization of our economy means that it DOES matter what goes on in other parts of the world and this was such an example. Our BCI system has a strict series of fundamental, technical and common sense screens that lead to our weekly published stock screen and watch list. As a result of Friday’s market decline many of the technical trend and momentum parameters were not met and only 1 stock (XEC) passed ALL screens. Please note that XEC is NOT eligible for a covered call write until after the 2-16 earnings is reported. Stocks that pass all fundamental screens but have mixed technicals are also eligible but conservative investors may opt for in-the-money strikes for additional protection. There are many such stocks located in this week’s “running list”.
Historical Options Data Charts:
For those who missed it, there was a discussion on last week’s blog commentary regarding FREE sites to access historical options data charts. Thanks to Owen for supplying this information:
- Go to http://www.dailyfinance.com
- Enter the stock symbol for quotes
- On the left of the quote page you will see a hyperlink “option chain”
- When you see the option list, each of the options will be a hyper link
- If you click on the option symbol a small window will pop up with details, including a graph
- Go to http://www.cboe.com/DelayedQuote/AdvChart.aspx
- Enter the stock symbol in the upper right corner of the “company data” portion
- Click on “options chain” just above the company chart
- Select the expiration month you want
- Then click on the option description to show the chart for that option
***Premium members: This information is archived in the “resources/downloads” section of your premium site.
With global issues dominating the news, we shouldn’t lose site of the fact that our economic recovery is gaining momentum. Here is a summary of key reports released this past week:
- GDP (Gross Domestic Product) increased by 3.2% in the 4th quarter of 2010
- The Conference Board’s index of consumer confidence rose to 60.6 for the month of January, a huge jump from the 53.3 reading in December
- Consumer spending was up 4.4% in the last quarter
- The FOMC announced that there would be no change to its monetary policy which is designed to prevent deflation and support economic recovery
- New home sales rose 17.5% in December, much stronger than anticipated
For the week, the S&P 500 dropped by 0.5% for a year-to-date return of 1.6%.
Viewing a comparison 6-month chart of the S&P 500 vs. the VIX (CBOE Volatility Index) we see an uptrending S&P 500 (+15%) and a declining (although oscillating) VIX (-18%):
A closer look at what has transpired over the past month paints a bearish short-term picture with the S&P 500 up a modest 1% and the VIX rising (a bearish signal) 14%:
An increasing market volatility (VIX) normally has a negative impact on the price movement of the general market (S&P 500). Since this is a small sample it raises an eyebrow but (in my view) is no reason to conclude that the market is turning bearish.
IBD- Uptrend under pressure
BCI- Cautiously bullish selling mainly in-the-money strikes
Wishing you the best in investing,
Alan ([email protected])