Category Archives: Trading

“naked” short sales

February 28, 2010 By in "naked" short selling, short selling, Trading Tags: , , , , , , Leave a comment

Settling a trade

Every stock market in the world has procedures for how a trade is settled, that is, where and when the buyer brings his cash, the seller his stock and the two complete the bargain entered into when the trade was agreed to.   In the case of the US, this usually occurs three days after the bargain is struck.

Curing a failed trade

Every stock market also has standard procedures to deal with a trade that “fails,” that is, cases where the deal isn’t completed, because one party or the other doesn’t show up or brings the wrong amount of money or the wrong amount of stock.

Penalty fees may be involved.  And, if the seller can’t deliver the stock he has promised to the buyer after a reasonable (but short) amount of time, the broker typically is authorized (and legally required) to buy the agreed-upon shares in the open market, deliver them to the buyer from the original trade, and send a bill to the seller.

“naked” shorts

This brings us to “naked” short sellers.   Before the short seller enters his “sell” order, he is supposed to have good reason to believe he can deliver the required stock on settlement day.   As I mentioned in my first post on short selling, there is an elaborate infrastructure in the US devoted to stock lending, the process of making stocks available for short sellers to borrow.  So the short seller should have a very good idea whether borrowing a given stock is possible or not, and how long it will take to get the stock into his hands.

A short seller who pretty much knows he can’t borrow a given stock, or has no intention of borrowing the stock, but sells it short anyway is called a “naked” short seller. Generally speaking, except for market makers providing temporary liquidity to a market, the practice is illegal. Until the past few years the rules weren’t enforced, so naked shorting occurred anyway.  In the best of circumstances, the buyer ended up being an uncompensated lender to the short seller, who was avoiding posting collateral and paying fees to a stock lender.  At worst, the short seller was trying to manipulate the market in a given stock.

market makers vs. hedge funds

I think it’s important to distinguish here between the activities of market makers in a given stock and those of professional investment managers, like hedge fund operators, who may sell a variety of stocks short.  Both may be “naked” short sellers.  But their activities are very different.

A market maker who sees an imbalance of buyers over sellers in one of his stocks may provide liquidity to the market by shorting shares to buyers.  His intention is to buy the shares back quickly himself to reestablish a neutral position, not to borrow the stock from a third party (and pay fees).  Clearly, the market maker intends to make money from his shorting activity, but one can reasonably argue that his actions have a stabilizing function.

This is very different, I think, from the actions of a professional investment manager, who from the outset doesn’t intend to honor the bargain he makes with a buyer.  He depends instead on the rules against naked shorting not being enforced so that he can evade his contractual obligation for as long as possible.

His actions are basically destabilizing, since he is overriding one of the basic safety features of any market that allows short selling–the requirement that you can only sell stock you have an ownership right to.

Why is this distinction important?–because advocates of naked shorting seem to me to deliberately muddy the waters by citing the benefits of shorting by market makers as a defense for the destabilizing actions of some professional money managers.

What’s wrong with naked shorting, in my opinion

1.  The regulatory requirement that a short seller be able to settle his trades is a reasonable one.

–It ensures that the buyer is able to profit if his “buy” decision is correct, instead of winding up with a failed trade and a stock that has run away from him.

–It also eliminates the possibility of bogus transactions by short sellers who can’t borrow stock, or who don’t want to post collateral or pay fees, yet who want to defend their short positions by impeding the upward movement of the stock.

2.  The need to borrow shares sets a natural limit (the number of shares outstanding) on how how many shares of a company’s stock can be shorted.  In practice, the limit to shorting is actually lower–the number of shares that holders are willing to lend.  The ability to create phantom shares through naked shorting tilts the playing field sharply in favor of short sellers.

3.  From a tactical point of view, holders of a stock have two defenses against short sellers, both of which are neutralized by naked shorting.  They are:

–Owners can call back the stock their organizations have lent to short sellers, forcing the latter either to find shares to borrow elsewhere or go into the market and “cover” (buy back the stock) their short positions.  Or,

–holders themselves can enter the market as buyers and try to support the current price by absorbing all the stock for sale, and potentially drive the price higher.

Either tactic can create a “short squeeze,” that is, a self-perpetuating scramble of short sellers to cover their short positions that, like a snowball rolling downhill, pushed the stock price considerably higher.  However, naked shorting removes these risk elements for short sellers.

You can’t call back stock that has never been lent and exists only in the imaginations of the short seller and his broker.  You also can’t dry up  the pool of sellers if they can “manufacture” new stock to short out of thin air.

A problem until 2005

That’s when the SEC instituted Regulation SHO, which makes brokers to follow rules that were already on the books.  In particular, it requires brokers to:

–document that borrowed stock is available to settle a trade before the bargain is struck, and

–“close out” a trade that has failed for 13 consecutive trading days by buying in the securities and delivering them to the original buyer.  The close out rule only applies, however, to stocks that exceed specified levels of failed trades.

In the link to the SEC website above, the agency is at great pains to point out that it does not regulate “pink sheet” stocks, seemingly implying that naked shorting is common there, even today.

There’s also academic research demonstrating that manipulative naked shorting was prevalent until Regulation SHO, after which it has substantially disappeared.  Oddly enough, I first became aware of this paper by reading commentary in Barron’s that made fun of SEC concern about naked shorting of Bear Stearns and Lehman (the paper concludes there wasn’t any–thanks to Regulation SHO).

Why is this important now?

The SEC is reviewing its short selling regulations.  It has just reinstated a modified uptick rule and proposes looking at naked shorting next.  There’s bound to be brokerage industry argument that Regulation SHO isn’t needed because naked shorting wasn’t a factor in the collapse of financial stocks in 2008.  But that’s just not true.


The perils of market timing–including one people don’t realize

February 1, 2010 By in market timing, Trading Tags: , , , , , , , Leave a comment

What it is

Market timing isn’t following the business cycle by rotating a portfolio to make it more aggressive or more defensive as economic conditions change.  It’s not selling a stock when you perceive it to be overvalued and replacing it with something else.  It’s also not using limit orders to buy or sell at more favorable prices.

It is the attempt to gain performance by raising large amounts of cash when the market is at a top and reinvesting it at a subsequent low.

Timing the market vs. time in the market:  the conventional case against timing

The cliché is that equity investing is not about timing the market, but about time in the market. Continue reading →

Trading: how valuable is it to do?

December 18, 2009 By in Constructing a Portfolio, Getting financial advice, How your broker gets paid, Trading, trading: how valuable? Tags: , , , , , Leave a comment

For professionals, very…

The short answer:  my experience is that competent professional trading supporting an equity portfolio manager can add one percentage point to annual returns.  Conversely, poor trading can subtract about the same amount.  Good trading, then, can take a third-quartile manager and put him in the second quartile; bad trading can do the opposite.

…for us, not so much

What about for you and me, though?

I think the key question for any individual investor is how much time is he willing to devote to investing.  A typical professional spends fifty hard–that is, not counting chatting in the coffee room with colleagues–at-the-desk working hours a week on his craft.  Even so, that’s not enough to keep pace with professional competition.  So the job of investing is usually split into three parts, one of which each professional in a firm will concentrate on.  The three are:  research, trading and portfolio management.

Realistically, we’re not going to work as hard as that, no matter what we tell ourselves.  So it’s essential for us to simplify and prioritize our activity so that we can do one or two things well, rather than do a half-baked job on several.

Committing our time to investing

As far as time commitment goes, I think the three parts break out as follows:

1.  portfolio management. Learning how to formulate a strategy takes the most time initially.  Once you actually create one, you’re thinking of it in odd moments most of the time, but your real work of testing, evaluating, trying to figure out what will come up next, is only done for short periods once or twice a month.  In terms of everyday effort, this most important part of managing your money takes the least time.

2.  securities analysis. Selecting the individual stocks, if any, for your portfolio requires a considerable initial effort to learn about he companies, their histories and their prospects.  Monitoring company developments and the stock’s price action takes daily attention if you want to do things right.

3.  trading. Trading can absorb your entire day, if you want it to.  After all, investment managers pay their traders hundreds of thousands of dollars yearly to do just that–to watch the markets, from overseas and pre-market activity to after-hours trading.    The question for us is whether, if we’re going to devote, say, 15 hours a week to our investments, becoming expert in this area is the most valuable use of our time.

(I probably should mention that I do have a  trading experience.  For about five years I ran a global fund where I was the manager and also did all the trading.  I won’t claim to be a really proficient trader, but I’m not that bad.)

Trading takes up a lot of time

An example:  one of my sons, a twenty-something, asked me recently to sell the (small amount of) PALM that he owned and put the proceeds into ATVI.  He had bought PALM, which I consider a really speculative stock (too much so for me), after a Bono-related investment vehicle had given the company an infusion of cash that would allow it to complete and launch the Pre. My son later became convinced that the Pre was going to be upstaged by the raft of Android phones now being released–which is why he wanted to sell.

Anyway, my son gave me a limit of $12 for PALM and none for ATVI.  I placed two limit orders online, one for PALM at $12 and another for ATVI about 2% below the previous close.  I thought the market was going sideways and both stocks were volatile enough intraday that the limits would likely hit.  I then did other things.

On day one, nothing happened.  On day two, prior to the open an analyst released a buy recommendation on PALM that pushed the stock up to $12.27 in early trade.  The stock faded as the day went on and closed at about $11.65.  Of course, I had sold at $12.  on day three, ATVI fell about $.05 below my limit intraday, before closing slightly above it.

Could I have done better?  Yes.  Speaking strictly about trading PALM, I could have spent all of day one and the first couple of hours of day two watching the market.  When I saw the new buy report on day two, I hopefully would have let the stock run and sold at, maybe, $12.20.

For us, it’s too much

But that would have meant spending eight or nine hours monitoring trading in PALM to get another 2%.  As one of my first bosses told me when I was talking about making a trade that might get me 10%–our job is to look for the 30%s and the 50%;  105 is too little to waste time and energy on.

To that, I’d add that if we’re going to allocate ten hours a week to investing, it’s better to spend that time trying to find the next AAPL rather than blowing a week’s worth of time looking for a 2% that may or may not be there for the taking.

Why do all the discount broker ads talk about trading, then?

Three reasons:

1.  The obvious one.  Trading is the service a discount broker offers.  The more you trade, the more money the broker makes from your account.  (See my posts on how your broker gets paid.)  The broker will also benefit if your account grows, but he will gain more from high turnover in an underperforming portfolio than from a low turnover one that outperforms.

2.  Trading tools are easy to provide.  You can even get them for free from Yahoo or Google.

3.  Offering trading advice is much simpler than offering investment advice.  Giving investment advice to a broad range of customers isn’t cheap or easy.  The broker opens himself to the risk of litigation if the investment advice proves unsound or if it is unsuitable for the economic circumstances of a given client.  So the discount broker has to have a research staff (which will end up costing the firm a lot of money) and representatives who will do risk tolerance and other suitability analysis.  Suddenly, the firm that does this not a discount broker any more.  It’s an old-fashioned “full service” broker.

Besides, discount brokers already offer back office services to independent financial planners.  So they would be competing against their own customers.