The Short Selling of America

Posted: October 7th, 2011, by DCTrader

       I started trading the stock market from my desktop computer in January 2001. And what I first thought would be relatively “easy money”, I soon found out was a long and costly educational process that continues to this day. And in that educational process, one of the first things I learned about was this thing called the “Uptick Rule“. The rule prevented you from short selling a stock unless the price of that stock was moving higher. The rule was put into effect in 1938 after concentrated short selling was deemed to be a contributing factor in the market crash of 1937. The rule has also been credited by many, as being one of the most important technical rules, that helped bring us out of the great depression. I argued in a previous article that the repeal of the Uptick Rule was the cause of the market crash in 2008 – and much of the economic woes that we face today. But how did this rule actually work to protect the integrity of the market? And what are the underlying mechanics at work here?

       The short answere to the first question is “It buys time”. To understand what I mean by that is a little more complicated – so I’ll expand on it. It buys time for the market maker or hedge fund manager who is trying to defend the price of a particular stock, by allowing other market players absorb any aggressive short selling. Remember, when the Uptick Rule was in effect, short sellers could still pin the buyers down by puting their sell orders on the “ask“. But they weren’t allowed to drive a stake through the heart, so to speak. For example, let’s say you have a company with the stock symbol XYZ. And a hedge fund manager is defending the stock by buying any and all of the sellers at $8.50. So that buyer maintains a buy order on the “bid” at $8.50 and is ready to back that up with millions of dollars. Remember, this would be on a “downtick“, so short sellers would not be able to sell it at $8.50 in this situation. The best that they could do here is put their sell orders in at $8.51. So let’s say they do that, and are ready to absord all of the buying at $8.51 with a few million dollars themselves. In this hypothetical scenario, the actual owners of XYZ’s stock would not be panicked into selling their stock – because they’d see that some big market maker was holding the line at $8.50. And unless there was some bad company news or earnings report …, there would be no reason to worry. Not only that, other buyers would start to move in and take out the short sellers at $8.51. So it cost the defending market maker alot less to hold the price of the stock. In today’s market, without the Uptick Rule, the short sellers can use unlimited funds to pound that stock at $8.50 – and break any market maker trying to defend it. It’s important to understand that both the money, and the motivation for selling are separate and different between sellers and short sellers. Think of short sellers as someone making a side bet against the stock you just bought. That, in and of itself, is ok. But it’s another thing altogether, when they’re allowed to use those bets to artificially drive the price of the stock down. And of course, make tons of money in the process.

       I remember hearing Suze Orman say in an interview, that over a trillion dollars “vanished” from peoples mutual funds and 401k’s when the stock market crashed in 2008. But in reality, money can only change hands in the stock market – it doesn’t vanish. If over a trillion dollars was lost from mutual funds and 401k’s when the market crashed, then it was the short sellers that made over a trillion dollars on those tranactions. So it’s easy to see why there’s big money interest out there willing to defend the removal of the Uptick Rule. There’s also traders who like it because of the huge swings that occur regularly, ever since the rule was eliminated. But for the sake of the world economy, it just isn’t worth it. I remember back in the day, when the market would sell off in Japan or overseas somewhere, the U.S. market would act as a stablizing force to those markets in the days that followed. But today, with the slightest blip in the markets overseas – the short sellers are out in force to pound the market down here. Hardly the stablizing force that it used to be.

       So who’s really to blame for the mess that were in? I lay that blame squarely on the SEC members that removed the rule on July 6, 2007. I remember hearing in the years leading up to that, the SEC was being lobbied heavily by some hedge fund managers to eliminate the rule. I blame those folks, too. If there was ever a conspiracy to be found, it might be here. Wouldn’t you be curious to know whether those same hedge fund managers that lobbied the SEC, made fortunes by heavily shorting the market before the collapse? Or even worse, used that short selling to help cause the market collapse in the first place. But I also blame the SEC today. The SEC could reinstate the Uptick Rule tomorrow, but for some unknown reason refuses to do so. These SEC members who refuse to reinstate the Uptick Rule, for whatever reason, should be fired for incompetence. Because they don’t understand basic market physics, and despite overwhelming technical evidence that shows the negative effect to the market since the rule was eliminated – they refuse to see the obvious. Does anybody really think the elimination of the Uptick Rule would serve to benifit anybody other than short sellers? Obviously, it made short selling easier – and that makes defending a stock’s price much harder. It’s rediculas when you think about it. I’ve heard so many phony-baloney reasons why the Uptick Rule was no longer necessary. I’ve heard people claim that high frequency and algorithmic trading makes the Uptick Rule obsolete or useless. Or another one I’ve heard is “because there’s so many people trading on home computers, it was no longer necessary”. In reality, the opposite is true. High frequency and algorithmic trading makes the Uptick Rule even more necessary. Without the Uptick Rule, dangerous algorithms that could crash the market could easily be devised – if they haven’t been already.

       But how does all this relate to things like the high unemployment rate, or the floundering housing market? Believe it or not, it actually does. It’s easy to see how events in the world or in the economy can affect the stock market, but a volatile market also reflects back – and causes uncertainty that affects the economy. Unemployment is not going to improve very much until stability is brought back into the stock market. It’s also important to note that the Dow Jones was trading between 13,500 – 14,000 before the market crash in 2008. So all of those business, that hire so many people – were worth more money, and able to hire more people. And of course the housing market is also directly affected by the unemployment rate. Bring stability back into the stock market, and you’ll bring stability back to the whole economy.

       On a final note, I’ve heard a lot of talk about “some new version” of the Uptick Rule. These are the same folks pushing this, that were behind its removal in the first place. And the reason for this is to render it useless. One version that’s actually being concidered only kicks in after the stock has dropped 10% on the day. That’s kinda like going to the store to buy some concrete to fix a crack in a dam, after the dam broke and all of the water’s already drained out! Absolutely useless. It’s important that any “modified” Uptick Rule does not have “triggers”. Stability will only come when the “buyers” are allowed to defend their ground, without being assulted by short sellers – at any time. Not after they’ve already lost a big chunk of their money.

- DCTrader –              © 2011 R.E.S. Enterprises

Post your comments on the Forum.

Technorati tags: , , , , , .