How To Fix the Broken US Economy (Part 3)

By Guest Author Bill McGinnis, CFA

A Short Take On Short Selling And Put Options

Short selling (selling shares you don’t own in the hope of profiting by buying them back at a lower price in the future) has become a lightening rod since last fall. The issue – is short selling exacerbating or even causing the financial crisis?

Short selling originated over 400 years ago and has been a common practice in stock markets for over 100 years. Why would it only now become a problem?

There are two important answers to that question:

This isn’t the first time short selling has been a problem. The most notable instance began with the crash of 1929 and continued through most of the Great Depression.

In 1938, believing short selling was contributing to unstable financial markets, the Securities and Exchange Commission (SEC) instituted rules constraining short sales. These included an uptick rule, which basically said shares couldn’t be sold short on a decrease in price. These rules were seemingly effective. However, in 2007, at the request of short sellers, these rules were eliminated. Approximately a year later, we again had another financial crisis on our hands.

For many, the logic behind allowing short selling at all is difficult to grasp. Why should you be able to sell something you never owned? There aren’t many instances in economics where this scenario is replicated.

However, short selling does bring a degree of balance to financial markets. It allows people with divergent views to each have the opportunity to profit from their potentially superior analysis. The ability to act on these contrary views “in theory” provides for greater pricing efficiency (a fancy way of saying prices that more closely reflect value). Short selling also provides market liquidity through the availability of shares to market-makers and other firms that help keep stocks trading (that’s a short way of saying what could actually be given a thousand words or more).

As someone who has studied and participated in the markets for over 35 years, I do believe short selling has an appropriate place. However, unrestricted and under-regulated/under-monitored short selling is a significant problem. It provides the opportunity for unscrupulous “investors” to either individually or in concert drive down the price of a company’s shares. It also incentivizes the spreading of false information about companies whose shares one has shorted. Does this really happen? Almost certainly.

In an email that was sent to the presidential candidates last September, I recommended immediately re-imposing the short sale uptick rule. The SEC got it right at the end of the Depression by implementing the uptick rule. Its elimination in 2007 was a big mistake.

In November 2008, I suggested in an unpublished opinion editorial piece that short selling had contributed to the destruction of some of the country’s most notable financial institutions and was on the verge of driving Citigroup out of business. While the November pressures abated, they recurred in March of this year.

We are still in need of significant limitations on short selling. The uptick rule would likely serve the purpose. It’s difficult to comprehend the foot dragging. There is little to lose and potentially much to gain by re-imposing the uptick rule.

From here, the question could logically progress to restricting or banning put options as well. (Put options are contracts to sell a fixed number of shares at a fixed settlement price in the future. As with short-sellers, the buyer of puts profits when the price of the underlying shares declines).

On the surface, it may seem that short selling and put options present exactly the same problem. That’s not really true. Put options are often used in hedging strategies where the buyer of the put may also own the underlying shares, or have also sold put options at a different settlement price, or may also own call options. (Call options are the opposite of puts in that they become more valuable as the price of the underlying shares increases. My apologies, but this is another area where over a thousand words would be more appropriate, but exceeds the scope of this commentary).

The biggest difference between short selling and put options is an issue of supply and demand. In a short sale, the person selling the shares is “borrowing” them from someone who owns them. The owner doesn’t even know this is happening…but it is. The entire borrowing mechanism is handled (at a significant profit) behind the scenes by brokerage firms.

So, if Company ABC has 100 million shares outstanding, there are 100 million shares that can be bought and sold without short selling. However, if there are short sales of 10 million shares (remember, these share have been borrowed), then there are now 110 million shares that can be bought and sold. The short sales in essence create new shares. Basic economics would suggest that more shares, equals more supply, which would result in a lower price. This is a disturbing equation.
In contrast, put options can only be bought if someone else will sell them to you. This process starts with someone believing that the price of the shares is likely to increase. Why else would someone sell something that increases in value when the price of the underlying shares goes down. Every put option purchased has an opposite investor (the seller) who believes the price is going up.

Notice the difference between a short sale and the purchase of put options. The shares sold short are created out of thin air, but the put option purchase requires a counter-party.

I think there is certainly room to question whether we’d be in a financial crisis at all if the short sale uptick rule had remained in place. (I’m not suggesting that there wouldn’t have been any economic problems, only that it may not have been a crisis.) It is even easier to believe that the lack of regulation has exacerbated the problem.

I don’t believe the same can be said about put options.

This segment is part 3 in the series : How To Fix the Broken US Economy
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