Thursday, March 11, 2010

The New Short Selling Rules

Short selling is the practice of borrowing shares from ones broker with the goal of price dropping then selling the borrowed shares, capturing the difference in price as profit. The practice has always had its supporters and detractors. Supporters believe that shorting adds liquidity, provides more opportunity for investors and lowers trading costs. Detractors state that unfettered short selling causes volatility spikes, market panics and crashes.

As late as 2007, the SEC moved to eliminate the depression era uptick rule providing greater freedom to short to short selling traders. The uptick rule only allowed you to short a stock after an uptick, or upward move in price. Although savvy traders had methods called conversions or bullets to legally work around this rule, the elimination of the rule opened up shorting to many more traders and stock situations.

The more rabid among the anti-short selling tribe draws correlations between the squashing of the uptick rule and the fall of Bear Sterns and Lehman Brothers. In the new rule, the SEC attempts to placate the anti-short sellers without causing too much adverse effect on the stock market.

Fortunately, the SEC is finally stating that it understand the true benefits of short selling. The new regulation prohibits short selling of any stock after it has experienced a 10% or greater decline. The rule would go into effect the day of the decline and last until one day after the drop. Why did they choose 10% as the threshold? My research canĂ¢€™t find any studies or empirical data that support this figure.

The new regulation will go into law in 60 days and the exchanges have 6 months to implement it. While I donĂ¢€™t support any governmental interference into the functioning of the free market, this regulation appears to be the least onerous of the possibilities. Given the fact that there is a loud, vocal minority within the government calling for the total elimination of short selling, traders and the free market itself got off the hook easy this time.

This rule will not affect most traders, even those who short regularly. As you know, we believe in shorting into strength, not weakness. In fact, empirical studies have found time and time again that odds are better for successful shorting when a stock is overbought showing strength. If you follow the basic rule of shorting into strength, the new regulations should have zero effect on your day to day trading activities.

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