From the above article:
Commissioners who voted for curbs when a given stock falls 10 percent from the prior day’s closing price did so without proof that it would improve markets, said Erik Sirri, who ran the SEC’s division of trading and markets during the credit crisis that began in 2007.
Well duh – of course they were! Anyone who knows anything about markets knows that short selling is needed for an orderly market and to allow hedging of risks. It is also part of a free market. Let’s first analyze what a short sale is, then how it is used, and finally, the dangers of short selling.
What is a short sale (for stocks not real estate):
Basically, it’s borrowing stock from someone else now, selling it, and hoping the price drops so you can buy it later a lower price and give it back – where you pocket the difference.
How Are Short Sales Used?
Short sales are used for various reasons including:
1. pure naked profit – you short a stock you think will drop, in order to make a profit. If the stock rises instead, you are willing (and hopefully able!) to take the loss.
2. hedging a portfolio – there are actually a few ways to hedge using shorts, I will cover a couple. One example is, let’s say you own a portfolio of stocks that you like, and you have profited handsomely. You fear that the market may fall but you don’t want to sell your stocks. You may short shares of companies which you think are weak, and then if the market falls, your short profits will offset some losses on the stocks in your portfolio – especially if you feel that your “longs,” the stocks you own, are stronger companies than your ‘shorts” – the stocks you sold short.
3. Original hedge fund – one of the original ideas of a hedge fund (hence the name) was a planned, and (hopefully) well thought out “long short strategy.” For example, right away you buy companies that you feel are strong, and short stocks of companies that you feel are weak – this could take place under various allocations – 70%/30% long short, 130%/30% long short, or even 150/100%. As a quickie example, you like Pepsi stock but are not so hot on Coca Cola stock. You buy $10,000 of Pepsi, and at the same time, you sell short $10,000 of Coke. Your goal is incremental – if the market rises, you expect Pepsi to rise FASTER, and if the market falls, you expect Pepsi to fall SLOWER. For example, in this hypothetical scenario, the market rises 1% (as measured by the Dow Jones Industrial Average), and if Pepsi rises 1.5%, you will earn $150 on your Pepsi stock and if Coke (if it DOES perform weaker than Pepsi) only rises 0.5%, then you lose $50 on your Coke “short – therefore net profit is $100 for the day and you are considered market “neutral.” This also happens if in a down market, for example again, the market falls 1%, Pepsi only falls 0.5%, you lose $50 on your Pepsi, but let’s say Coke falls 2%, you would gain $200 on the $10,000 short of Coke – net profit = $150.
The caveat is , you better do your research because this is hard! If you make wrong choices you can end up MULTIPLYING YOUR LOSSES!
Dangers of Short Selling
A few reasons that, over the long term, the odds are stacked against the short seller…
1. long term uptrend bias of market – the market has trended up over the last 120 years, so being short is more of a precision art/skill than a long term idea, unless you have a long term stinker like Government Motors (GM).
2. dividends – if you are short a stock, you have to pay the dividends to the person from whom you borrowed the stock! Therefore, if you are going to short a dividend paying stock, you may end up with extra costs in dividends paid.
3. share buybacks – if the shares drop enough, and the company has enough cash on the balance sheet, they could prevent a stock from dropping too far if they buy a lot and if a stock does hold up well as you try to short it and earn a profit, you could get caught in a –
4. short squeeze – if many people are shorting a stock, and the stock starts to perform well, many short sellers may want to buy the stock back and completely exit the trade. The only problem is however, that if one wants to exit, one has to buy and if many short sellers want to exit, many have to BUY and buying does what to a stock price? Drives it up – a potential huge loss creator.
Which brings us to the point of this whole article. In the fall of 2008, the SEC restricted short sellers from shorting certain stocks, especially financial stocks, in order to try to prevent them from driving down the price. Even the CEO’s of some of these financial companies, who KNOW better, were on TV blaming short sellers. But as we reviewed above, it is VERY DANGEROUS to be short in a large way unless you are sure.
If these financial companies were legitimately financially strong, they could have bought back shares when their stock price dropped from 100 to 2 – why didn’t they? Because they were WEAK companies and the short sellers were correct to expose them. The reason for the short sale ban was for POLITICAL reasons because you have to blame someone besides the actual guilty party (the American way).