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The Uptick Rule and the Shorting Ban

Q: What is the uptick rule and can it really help soften a market crash?

A: The uptick rule originally applied to normal stock trading. This rule decrees that a stock can only be sold short above the last price traded and was put in place to prevent ‘bear raids’ that would allow people to target a company by rapidly shorting shares on the way down. Basically it means that to enter a short sell position the stock has to rise before you can do so if the market was continuously falling without ever moving back up (even 1 cent) then you would miss out on the trade. In 2007 the SEC revoked the uptick rule and some people believe this lead to the collapse of companies like Bear Stearns, Lehman Brothers, etc. However, the truth is that option market makers were always exempt from this rule as meaning when they are hedging their option risks they could sell on a down tick. Therefore, smart money got around this rule by buying a put and selling a call (synthetic short). The investor then uses the market makers exemption to get around this rule as they hedge by selling shares without waiting for an uptick. With CFDs the uptick rule doesn’t apply so you can sell in a free falling stock without problems.

Q: Can short-selling destroy a company on its own?

A: In theory no. At some point buyers will buy into an undervalued company and realise a healthy profit and in so doing support the share price (which is only really important only if the company risks being taken over or need to raise additional capital).

In practice, share prices do matter and as a blogger has rightly commented a loss of confidence when they fall can be extremely damaging – as we have seen in banking. He has commented that many companies have loans and warrants which are secured against shares: so if the price drops, there is an immediate risk that loans can be called in, and a longer-term cost in raising finance. In a credit crunch, companies with a volatile share price, or a low one that represents a weak asset base, will be unable to raise money at all. Worse, companies in the financial sector may have statutory capital adequacy requirements which count their share capital as part of the ‘permanent capital’ of the company. So a company can run into serious financial and regulatory difficulties it the share price falls. Plus, of course, they will become a takeover target.

Q: So what are the regulators doing now?

A: They’ve forbidden short-selling in financial stocks – temporarily – because the practice is particularly damaging to companies in a confidence-based business with regulatory capital requirements. Investors have also been banned from using CFDs, options or spread betting to take a bet on banks falling in value.

Longer-term, there will be much tighter control: no ‘naked’ shorting, a deposit to the lender that fully covers the share price, immediate disclosure of how much stock is out on loan and – probably – some kind of limit on how much of a company’s share capital is available for shorting at any given time. I am certain that there will be ‘speed bump’ limits that halt short-selling if a target company’s stocks fall more than a set amount on a given trading day.

Q: Why are hedge funds and shorters being blamed?

A: Traditionally hedge funds have been made accountable for substantial portions of the short-selling. In practice, however, it is simply human nature to seek a scapegoat. Certainly, it seems that whenever the markets are in free fall and losses are leaving blood on the Street, there is a scramble to find someone to blame.

The last time the markets plunged in the wake of the Dot-Com bust where equities fell more than 40% between 2000 – 2003 hedge funds were also blamed. During that period, many listed companies and long-only investment institutions complained loudly about hedge fund behaviour, and some institutions even withdrew from the stock-lending market to try to counteract the shorters.

Most hedge funds are however ‘long/short’ funds, so they take as many ‘long’ positions (buying shares) as short positions, so even if they were big enough to significantly move prices, they would be pushing some share prices up and others down.

The current market is volatile, yes, but that’s not the work of hedge funds or short sellers – it’s simply a result of the collective realisation that too much money has been leant to people and institutions whose creditworthiness is now in question.

Q: What has been the hedge funds reaction?

A: Hedge funds have complained about the way disclosure of short positions was pushed in a such a hurried way with no process and consultation.

Hedge funds have also commented that the short-selling freeze could make it more expensive for banks to raise capital. They claim that even though the ban may bring temporary relief it creates an artificial market. Hedge funds say that the ban will not ultimately, on its own, bring back investor confidence in the banking system. Some market participants also saw the short selling ban as an unjustifiable infringement of their freedom to trade, irrespective of the banking sector’s troubles.

Q: What is Warren Buffet’s take on short selling?

A: Warren Buffet does not short companies. On this shares, however Warren Buffet stated that he will willingly lend shares of his company to any short seller. It seems Warren Buffett is not concerned about short sellers because he knows that eventually a short seller is not only a future buyer of his shares but he also gets paid for lending his shares. He has confidence in his business and value creation and that this will be a profitable proposition for him.

Q: Will disclosure of short positions make any difference?

A: I doubt this would make much difference but it will help transparency. Say you are a small investor and you read in the paper one morning that shorts account for 20% of the stock in your favourite company. What do you do then? Buy more shares thinking the shorts are wrong? Or sell thinking the shorts might be right? As always, the level of the share price versus your opinion on the company’s fundamental value is the main thing to take into consideration – as it always is.

Q: What led the authorities to issue a ban on shorting of financial stocks?

A: In September 15, 2008, the collapse of Lehman Brothers sent the global financial system into outright crisis mode. HBOS lost up to 40 per cent of its market valuation the following day as investors panicked and sold off its shares en masse terrified of gossip that the UK bank was owed big amounts of monies by the now bankrupt United States corporation. RBS’s shares also fell by some 10 per cent.

This forced the Financial Services Authority to issue a temporary ban on short selling of HBOS shares as the Authority was concerned that this was negatively impacting the share price of the bank (which share price had already gone through a painful ordeal the previous March, as negative rumours circulated amongst traders). This ban was soon after extended to cover the shares of 29 major financial institutions and a number of other countries like France and Australia followed suit by banning shorting on quoted financial institutions in their respective countries. In the UK the short-selling ban was lifted in January 2009 when the markets had started to stabilise but stricter disclosure rules still remain.

Q: Will the ban on short-selling financial stocks work?

A: When the dust settles I think we all realise that there are going to be major regulatory changes. One has to hope that the regulatory changes, however, deal appropriately with the cause of the current crisis and not the symptoms. Quite simply, a ban on shorting won’t wallpaper over the underlying cracks.

The problem with banning shorting is that attempting to stop, restrict or to control the free market mechanism, doesn’t remove the underlying problem. In reality, the markets are in such a state of flux, and now so complex, what may have been a kneejerk reaction to events could serve to worsen them after the initial ‘positive’ reaction.

If anything, all that the government is doing here is to remove the potential for a short, sharp, shock correction, and to replace it with a different type of painful correction, which is going to manifest itself in some other way which presumably the plate spinners will then attempt to regulate as well, once some other ‘disaster’ has come to pass.

Not very long ago the idea that short sellers (leveraged or not) would find fertile ground trying to make money out of shorting massive financial institutions would have been very far fetched. At that time the markets were orderly despite the existence of the leveraged players to which you refer that were participating in the markets.

What has changed now? It seems to me that what has changed here is not the actions of the shorters, but the discovery that the activities of these financial institutions was not as sound as they previously would have had us believe, in fact they have exposed themselves to risks so significant that they have undermined the perception of their own solvency. The fact that certain market participants use this fact to make money in such circumstances in my view is evidence of the market functioning properly.

The market was doing what it should have been doing, and ‘fixing’ the problems created by over leveraged debt underpinned by what the ‘free’ property market is now demonstrating to be over-priced assets. As those assets value are corrected negatively, the market must respond to ‘reset’ the value of the organizations whose value is supported by the servicing of those debts with the right to repossess the asset that is currently being negatively revalued. This will mean that some companies must disappear, and some must merge with others, but the important thing is that the correction is being made to fairly reflect the value of the underlying asset, at a time when there is no other way to measure it.

The issue is not short selling as such (other than the trust issues I alluded to elsewhere), but the ‘harmonics’ that appear to becoming more prevalent in the stock market such that we get massive highs and massive lows. And unfortunately when those harmonics hit a bank (or any other massively leveraged operation dependent on relatively short-term credit) the outcome is usually fatal.

Q: Should I be buying shares in a company after it has issued a profit warning?

A: Well, really this depends on the fundamentals of the company and what led the company to issue a profit warning in the first place. If it seems like a one-off event such as the loss of one major client you need to decide whether the company is likely to be able to replace the lost revenue in which case it might make sense to buy the shares in expectation of a recovery. If the profit warning affects the reputation of the company – such as when banks issue bad news, the shares could be in for a longer term battering in which case you might want to consider taking a short position on the stock. On the other hand if the company announces that they have experienced a sudden, steep decline in trading it is probable that another profit warning could be on the cards ahead in which case it might be best to take a wait and see stance.

The problem is that the market is an efficient mechanism, and any sort of intervention like this is nothing more than a knee-jerk reaction in order to try to resolve a completely different problem, in this case being the reason why these stocks are being shorted in the first place.

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