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Another Short-selling Ban?

Short sellers definitely get a bad rap.  Short-selling in and of itself is not inherently a bad thing.  With the news today that Chancellor Andrew Merkel of Germany would institute a short-ban on some financial institutions, as well as some European government debt, I have some thoughts I need to let out.

To me, the major distinction between short-selling and longing stocks lies in the fact that with outright shorting, the returns are absolute (i.e. the most a stock can go down is 100%) and with buying stocks, the returns can be exponential and theoretically infinite.  As an investor who prefers growth to value, short selling is not all that appealing.  Yeah I did buy some puts in Merrill and UBS back before the financial crisis (Merrill worked out well, but couldn’t UBS have dropped below $10 a couple of months earlier), but I’ve never found a successful short as rewarding as a successful long (a la a Dendreon).  Maybe that has something to do with the fact that shorts pay off in destruction and my longs pay off in innovation.

As a trader, my most successful run came during the U.S. short-selling ban way back on 2008.  This created a major inefficiency in the market and the liquidity structure changed and I found a way to exploit that to my advantage.  As much as it was personally rewarding, I thought it to be a downright awful idea.  The ban on short-selling popped stocks like Wells Fargo (take a look at the chart below), US Bancorp and others to insane valuation levels in the face of serious macroeconomic risk.  What the ban effectively did was create an out through which REAL sellers, people who actually owned this stuff, had either an opportunity to get out of their bad investments, or in some cases, the opportunity to sell stocks at what would have been very generous long-term returns.

All that being said, the area in which I truly believe in a ban on short selling is with regard to sovereign debt.  To me, that serves no purpose.  Short sellers add to levels of supply and interfere with a country’s ability to raise more money in times of need.  When it comes to sovereign debt, short-selling is a self-fulfilling prophecy in that the more shorts there are, the more dire the prospects the country’s ability to counter short-term solvency and liquidity troubles may be.  When it comes to sovereign debt, only the sovereign should have the power to sell its own debt, not a naked shorter.  We all have a vested interest in ensuring that countries do not fail, while in a capitalist country, it is of little consequence for a company to fail.  Sovereigns are very different than corporations, and as such they need to be treated differently.

Let’s wait to see exactly how this supposed “ban” plays out with Germany.  If they ban shorting on equities of financial companies, I think some troubling happenings could take place; however, I think of the ban focuses solely on sovereign debt it makes a whole lot of sense.

  1. May 18, 2010 at 4:30 pm

    Markets have become a very risky place both on the long and short side with governments coming up with new “bailouts” and “regulations” almost each day it seems.The new German ban on “naked short selling” effective from midnight has led to US markets declining along with the usual suspects like the Euro and the Pound.Oil seems to have decisively broken its trading band of roughly between $70-$87 since the last 6 months, probably indicating that the the markets might have made an intermediate high.Read more at http://greenworldinvestor.com

  2. May 18, 2010 at 7:48 pm

    The ban is actually only on naked short sales…which should be illegal anyway and are in the US. I’m not sure why it’s not illegal in Germany.

  3. May 19, 2010 at 4:59 am

    What is naked short selling? And why its illegal? Can anyone explain?

    • May 19, 2010 at 8:40 am

      Naked short selling is when someone shorts without finding an actual long to lend them their shares. In the U.S., when a short wants to establish a position, they must find an actual long to “lend” them their position in order to sell. This helps prevent someone from flooding extra supply on the market than truly exists. For example, let’s say there are only 100 shares of stock XYZ, a naked short of 2 shares would take the overall supply level to 102 shares, thus increasing the float. It is illegal because it artificially changes the supply/demand dynamics of that particular investment vehicle. Shorting is ok, so long as it does not alter the actual availability of the unit of investment.

  1. May 18, 2010 at 5:42 pm
  2. May 19, 2010 at 12:55 am

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