Trader’s Narrative

The SEC has recognized that the present rules for short selling haven’t worked out that well. It doesn’t take a genius to recognize that rampant naked short selling exacerbated the crisis, especially within the financial sector. The most egregious example is Bear Stearns but many other well known Wall St. investment banks saw their shares pummeled mercilessly late last year. As usual, the SEC is playing catchup. But if it acts intelligently it may still benefit everyone by creating a more stable, fair and balanced market.

As a consolation, any changes to the present rules won’t be sprung on traders as a surprise. We are presently in a 60 day consultation period, after which when or if a decision is made, it will be implemented after 3 more months to give everyone involved plenty of time to prepare. There are five possible options:

The first suggestion is to bring back the uptick rule that we have known so well over the past 70+ years. This was implemented in 1937 as a result of rampant manipulation of the market by wealthy speculators (the precursors to hedge funds) during the roaring 1920’s. It was eliminated July 3rd 2007 with little fanfare; The Uptick Rule: Nice Knowing You.

The disadvantage with the uptick rule was that it was easily circumvented by those that count. That is pro traders, institutions, etc. As always, in the end, the retail trader was left out in the cold while those with insider knowledge and more resources simply side-step the rules and sold short despite the uptick provision. Another disadvantage is that the market has become faster and more fragmented so it is getting harder to determine what exactly the immediate last price was. The advantage is that the uptick rule is well known to all market participants and it would be psychologically easy to simply revert back to them (or circumvent them, depending on who you are).

The second suggestion is to slightly modify the old uptick rule by making it more stringent: a short sale could only take place if the stock price traded at least a penny higher than before. I’m not sure what this slight ratcheting up of conditions really accomplishes. I suppose we could say 2 cents, 5 cents, and so on. In the end we’re really talking about a similar restriction to the old uptick rule with the same advantages and disadvantages.

The third suggestion is to introduce a restriction in trading only if a stock price experiences a decline of, say, 10% in a day. The simplest of these “circuit breaker” type suggestions is a blanket ban on short selling a stock that falls 10% within a trading session. This would be similar to limit days in commodity markets. Although, under this condition, the stock price could very well continue to fall much further than 10% - it simply couldn’t be pushed by short sellers.

The fourth suggestion is to soften the circuit breaker idea by just re-introducing the uptick rule for the remainder of the day if a stock falls 10%. So rather than no short selling at all, you could sell a stock short as long as it met the uptick conditions.

The fifth suggestion is to introduce a “bid test” if a stock falls 10% (in a trading session). This would mean that a short sale could occur only if it takes place at the highest available bid and not just an uptick.

My hunch is that if the SEC goes with any of the circuit breaker ideas it will introduce them in staggered fashion rather than in one fell swoop. There are two main perspectives on this sort of thing: leave the market alone and to regulate heavily. I fall somewhere in the middle. The trick is that while we do need to interfere with the market, it has to be done intelligently and minimally.

I can’t understand those that want a completely free market. We are constantly interfering with the systems that we live in. We have laws (that are constantly changing and adapting), we have police and courts that react to our behaviors and actions, etc. How is the stock market different?

The problem is when regulation is done with a sledgehammer it becomes outright intervention, which is at best useless and at worst, disastrous. If the SEC takes this short selling restriction too far, it won’t stop the practice but simply force it to take place in different forms and in different places. For example through swaps or other unregulated dark corners of finance.

Take a look at the Karachi stock exchange chart below to see what happened when the government of Pakistan put an artificial floor on prices:

Obviously a government mandated floor for stock market prices doesn’t work. And recall how last year, the SEC along with the equivalent regulatory body in the UK (the FSA) halted short selling from September 19th to October 8th 2008. Although it originally covered mainly financial and bank stocks, it was quietly expanded to include other companies as well. In the end, it had really as much effect as standing in front of a runaway freight and yelling ‘STOP!’.

But that doesn’t mean that we should throw our hands up and do nothing. Everyone involved with the market knows that naked short selling is a problem. It shouldn’t be allowed because it undermines the integrity of the stock market. If the SEC can put a stop to the abusive short selling practices it would go a long way in restoring confidence in the stock market. That would be much more productive than ruminating about the minutia of short sale restrictions.

The following charts are from Jason Goepfert, of SentimenTrader.com, showing his proprietary indicator called the “Panic Button”.

This indicator measures stresses in the credit market and is expressed as standard deviations from the norm. So a 2.0 means that the aggregate measures are 2 standard deviations from their usual or normal place. Yesterday it reached 9.5 (intraday) but has since come down to “only” 4.

Notice how it dwarfs all other major crisis in recent history! This is similar to the long term chart of the 3 month Treasury Bill rate I featured yesterday.

Here is the same chart, zoomed in to the latest few years:

It is not only awe inspiring, I’m left wondering what in the world it all means. Have we left reality and entered a bizarro alternate one? of what use is history and precedents when they are so out of proportion with what is happening right now?

Lynching Short Sellers
Then there is the rumor of the SEC moving to ban all short selling or as the FSA across the puddle, short selling related of financial stocks. Need I or anyone else, explain that this is completely moronic? Short sellers, far from being the culprits in this mess, are actually necessary for the proper functioning of price discovery. Furthermore, the effect of short sellers is to actually slow down a crash.

If that sounds counter intuitive to you, consider that every single share sold short is in effect, a future buy order. So as prices come down, it is short sellers who buy, in selfish interest to lock in profits - thereby providing some sort of friction to stall the downside momentum. Simple stuff. Economics/Trading 101.

But the current US administration is so dumb that they couldn’t empty a bucket of water if the instructions were glued to its bottom. While they attempt to forestall the inevitable, hoping against hope to buy time before a collapse before November, they are only damaging the economy of the US and the whole world by extension even further.

Get A Clue
By the way, if you aren’t yet aware of news.tradersnarrative.com you have no idea what you are missing! The rumour of the SEC’s move was on there hours ago and many other must read links get posted regularly. If you have an interesting link that you’d like to share or comment on an existing one, you can now do so.

In this quiet, shortened trading week, something historic will happen. As of today, July 3rd 2007 the ‘uptick’ rule will be eliminated.

If you’re new to all this, the uptick rule limits how a trader can sell a stock short. The rule only allowed short selling when the last bid wasn’t lower than the previous inside bid (Nasdaq) or for the NYSE, an uptick or zero plus tick. The intention of the rule was to prevent someone leaning into a stock and just hammering away at every single bid.

This was a rule that came about after the public uproar over the great bear market of the late 1920’s. It has been in effect since the SEC Act of 1934. This act not only brought about sweeping changes to the US financial markets, it established the SEC as the defacto guardians entrusted with policing the hobbled stock market.

A lot of good was done in the SEC Act of 1934. Pretty much everything we are now familiar with, from IPO’s, annual reports, quarterly statements, etc. all are thanks to it. But I am glad the uptick rule was thrown away.

It’s not like it was really accomplishing anything. For a long, long time now people have been getting around it. First using ‘bullets’ (or married puts) and then using single stock futures. Thanks to the ever changing landscape and the indefatigable creativity on Wall Street the uptick rule became the vermiform appendix of the financial markets.

If you want the complete lowdown, read the SEC ruling in full (pdf)