1. Short Selling Guide: Introduction
  2. What Is Short Selling?
  3. Example of a Short Selling Transaction
  4. Short Selling Strategies and Margin
  5. Timing a Short Sale
  6. Short Selling Analytics
  7. Short Selling Alternatives
  8. Risks of Short Selling
  9. Ethics And The Role Of Short Selling
  10. Short Selling Guide: Conclusion

Short selling is highly regulated by securities authorities around the world, not only because of its risky nature, but also because it is prone to manipulation by dishonest short sellers who may use unethical tactics to drive down stock prices. Such “short and distort” schemes and other abuses such as bear raids are more prevalent during severe bear markets. Not surprisingly, the two biggest recent changes in U.S. short selling regulations – Regulation SHO and Rule 201 – were implemented in the years after the “tech wreck” of 2000-02 and the global bear market of 2008-09 (see https://www.sec.gov/investor/pubs/regsho.htm and https://www.sec.gov/investor/pubs/regsho.htm). 

“Short and distort” is an illegal tactic used by unscrupulous short sellers wherein they short a stock and then spread rumours and innuendo to drive down its price. A bear raid refers to short sellers who connive to push a stock lower through concerted short selling and rumors of negative developments.

But it’s only a handful of dishonest and unprincipled short sellers who may resort to these tactics. The majority of short sellers are ethical and diligent individuals who are not out to crush companies or destroy the American Dream, but facilitate smooth functioning of financial markets through the following –

  • Providing liquidity:  By selling shares – albeit those that they do not own – short sellers provide much needed liquidity to the markets, which may compress bid-ask spreads and lower the purchase price of stocks.
  • Reality check: Short sellers act as a reality check on investors’ unrealistic expectations, especially during periods of rampant optimism. In the absence of their restraining influence, stocks could well trade at stratospheric levels and sky-high valuations.
  • Price discovery: By providing a contrarian point of view and going against the crowd, short sellers facilitate price discovery for stocks.
  • Diligent research: The risks involved in short selling lead the best-known short sellers to conduct research on their target companies that is unbiased, comprehensive and timely. A number of short sellers and hedge funds who have been among the first to highlight problems at large companies. These include:
  • James Chanos, who detected fraudulent accounting practices at Enron Corporation about a year before it declared bankruptcy in December 2001.
  • David Einhorn of Greenlight Capital, who publicly skewered Lehman Brothers at an investment conference in May 2001; Lehman declared bankruptcy in September 2008.
  • Carson Block of Muddy Waters Research, who was among the first to expose fraud at Chinese companies listed on North American exchanges. In 2011, Block alleged that Sino-Forest Corp, a Chinese forestry company with a market capitalization of $6 billion listed on Canada’s TSX exchange, was a multi-billion Ponzi scheme6; Sino-Forest filed for bankruptcy in March 2012.

Regulation SHO

In January 2005, the SEC implemented Regulation SHO, which updated short sale regulations that had been essentially unchanged since 1938. Regulation SHO specifically sought to curb the practice of “naked” short selling, which had been rampant in the 2000-02 bear market.

In a naked short sale, the seller does not borrow or arrange to borrow the shorted security in time to make delivery to the buyer within the standard three-day settlement period. (Remember that just as there is a seller on the other side of every buy transaction, there is a buyer on the other side of every short sale trade). This results in the seller failing to deliver the security to the buyer upon settlement, and is known as a “failure to deliver” or “fail” in short selling parlance. Such naked shorting can result in relentless selling pressure on targeted stocks, and cause huge declines in their prices.

In order to address issues associated with failures to deliver and curb naked short selling, Regulation SHO imposed “locate” and “close-out” requirements on broker-dealers for short sales. (The “locate” requirement is discussed in the “Example of a short sale transaction” section).

The “close-out” requirement is applicable to securities in which there are a relatively substantial number of extended failures to deliver (known as “threshold securities”). Regulation SHO requires broker-dealers to close-out positions in threshold securities where failure-to-deliver conditions have persisted for 13 consecutive settlement days. Such closing out requires the broker-dealer to buy back the shorted securities in the market, which may drive up their prices and inflict significant losses on short sellers.

 

Rule 201

Short selling was synonymous with the “uptick rule” for almost 70 years in the U.S. The rule was implemented by the SEC in 1938 and required every short sale transaction to be entered into at a price that was higher than the previous traded price, i.e. on an uptick. It was designed to prevent short sellers from aggravating the downward momentum in a stock when was already declining. The uptick rule was repealed by the SEC in July 2007. A number of market experts believe this repeal contributed to the ferocious bear market and unprecedented market volatility of 2008-09.

In February 2010, the SEC adopted an “alternative uptick rule” – also known as Rule 201 – that restricts short selling by triggering a circuit breaker when a stock has dropped at least 10% in one day. The SEC said this would enable sellers of long positions to stand “in the front of the line” and sell their shares before any short sellers once the circuit breaker is triggered. With U.S. and global equities recovering from a severe bear market at the time, the SEC also said that the rule was intended to promote market stability and preserve investor confidence.

 

 

 

 

 

 

 

 


Short Selling Guide: Conclusion
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