Long Live the Short Sale

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The ban on short sales in financials and companies tied to financials has ended.  Beginning this morning, investors will be able to bet against these companies.  While the experiment was meant to curb the free fall in these stocks, many market participants have determined that the practice of just issuing an outright ban was an outright failure.  Many of the stocks on that list have fallen more than 25%.

Short selling is controversial in a sense, but this practice is part ofan orderly and liquid market.  There were exceptions for market makersand options professionals, but the only way investors have been able tohedge stocks or portfolios was by selling S&P futures or by takingout more expensive Put options.

There has been zero liquidity in the credit markets, and corporate bondmanagers have been unable to hedge new positions by shorting a stock inthe corporate bond issue that they own.

The practice of "fair" short selling does need to be fixed.  Tradersfor a long time have been able to engage in naked short selling wherethe borrowed stock was not technically located nor was it reallyborrowed.  There has also been no "uptick rule" where a short salecould only be executed after a higher bid and ask are executed.  Thisissue still remains, and what the rules will be in the future is stillan unfinished chapter.

Outright bans often come with unintended consequences.  It is importantto realize that for every short sale that occurs, someone else took theother side of the trade by buying the stock.

Jon C. Ogg
October 9, 2008