Trivially naked short sales are short sales in which the security is not borrowed first.
That was easy enough. The implications are a little trickier though. Though heavily restricted since 2008, they still occur. They are easily abused, though opinions differ on how big an issue this really is. Some claim that naked short sales lead to the demise of BS and LB. Ever since that Rolling Stone article it seems to have gathered some momentum on the internet, for example. But there are plenty of people who think that’s bull, and much like short sellers in general, feel that naked shorts got a bum rap. I lean more towards the latter but don’t feel terribly strongly one way or another.
Soon after Obama took over the stock market was down to about 750. It has gone to over 1200. You can see what a boon that has been to the country. Well, you can ,can’t you?
I agree that shorting drives down prices but I don’t see the distortion or overvaluation caused by the lack of shortability. When I walk into an apple store and say to myself, holy cow those ipads are overpriced, does that mean that their price is incorrect if people are buying them for that price?
Now remember, the purpose of secondary markets in stock is to provide liquidity and a place for people to sell their stock so that people will be willing to buy the IPO in the first place.
So in what way does permitting shorts advance this goal?
The study you cite specifically says that it is not merely the lack of shortability that causes overpricing, it says that it is a lack of shortability AND a highly binary dispersion of opinions that cause stock to be overpriced. And how do we know they are overpriced? Because at some point some event occurs that confirms or repudiates the underlying assumptions that causes the unusual dispersion.
All they seem to be saying is that binary stock with a high short interest tends to significantly underperform the market. I don’t find that surprising or so undesirable that you can’t consider getting rid of the bad shit that shorting can bring.
Read your link again. I think you are confusing dedicated hedging for folks who take directional short positions. Just because I am not a dedicated short (I do nothing but short stock) doesn’t mean that my shorts are hedging positions.
Yes. I thought that should have been clear from one of my earlier posts. Naked shorting is the equivalent of manufacturing stock out of thin air (and thereby increasing the supply of stock) without borrowing the stock that you sell into the market. Shorting is actually borrowing the stock before you create a virtual share that you sell into the market. Shorting in every case creates shares that didn’t exist before and increases the supply of shares available to satisfy demand.
Incorrect evaluation of fundamentals is not something we can get rid of through regulation. Shorting is.
When did I say that a transparent liquid secondary market in government bonds was bad? I was responding to the statement that the bond market was much much larger than the stock market. My point was that people don’t trade bonds the way they trade stock, the bond market operates efficiently without a bond exchange because of the nature of bonds versus stock and so one has not developed.
And my point about maturity dates is that They are by definition limited in duration so even without a highly liquid secondary market, waiting for the maturity date is an option you have with bonds that you don’t have with stock. Stock does not have a maturity date so there is much more of a need for a secondary market.
Heh, if there was an appropriate market for it and I thought the price was likely to fall, sure. If I could borrow an iPad today, sell it, then use the funds to buy a cheaper iPad in the future to return to my lender, perhaps apple would be forced to lower their prices. Sadly the market for iPads is terribly illiquid…
Comparing equity with retail goods gets silly and this is heading for a derail fast, but let’s forget iPads: if people are willing to pay two million dollars for a 3 bedroom town home in suburban Las Vegas, who are we to say that price is incorrect, right?
The two statements “How do we know they are overpriced?” and “Stock with a high short interest tends to significantly underperform the market?” … you don’t see a relationship between these two statements?
CS explicitly notes the difference between directional shorts and hedging strategies:
"It is also interesting to note that while hedge funds do engage in short selling, most are not designed to specifically target companies by shorting their stock. Much of the hedge funds’ short selling is part of a strategy that matches short sells with long positions, as discussed on p 3.
As of the latest data from the Credit Suisse/ Tremont Hedge Fund Index (Aug 2008), a minuscule 0.7% of hedge funds was dedicated to short only trades. The balance is either long only or engaged in long-short strategies."
Where are these directional shorts that aren’t accounted for in the short, long-short, long breakdown? Unless you are saying the majority of this occurs outside the hedge fund market? Where are your cites for the breakdown of dedicated short vs long-short positions?
Do people realize how much shorting as a strategy sucks on a day-to-day level? There’s a reason it’s not as popular as critics might suggest. You have to have an incredible tolerance for risk and pain and you’re fighting the long term upward trend of markets in general.
Your argument seems to be that the lack of shorting facilitates bubbles or more accurately shorting prevents bubbles. I would submit that the real estate market is not nearly as liquid as the stock market and therefore more subject to bubbles. It can take months and 10% of the value of my home to sell it, it takes a mouse click to sell my stock.
the paper you cite specifically says that high short interest doesnt create overvaluation by itself it is only with a binary dispersion of opinion that this occurs. Binary stocks are not like stocks in general and they act very differently.
note the use of the word much and most and words like that. It’s nowhere near the 0.7% that you seem to think it might be.
my read of your cite is that dedicated short is a fund that does nothing but short. long short strategy doesn’t seem synonymous with shorting as a form of hedging. Like I said before I don’t think all these people are going long ford and shorting a basket of auto manufacturers they are going long on ford and shorting some uncorrelated stock like ibm. I know more than my share of hedge fund managers and frankly a lot of them don’t even trade stock but of the ones that do many are long some companies and short others based on their opinions about those companies not as a hedge against each other.
I don’t see the great benefit from shorting that justifies facilitating the abuses that we see from shorting.
No, I was responding to your argument that if you can find a willing buyer then you can’t claim something is overvalued. Remember when you wrote: “When I walk into an apple store and say to myself, holy cow those ipads are overpriced, does that mean that their price is incorrect if people are buying them for that price?” That’s ridiculous. I referenced the housing market as a recent example of people paying way more than something was actually worth. Those prices were incorrect, even though people were buying them for that price.
That short selling may have retard bubble formation is a separate issue, and a controversial one. I personally don’t think it can. Actually, I’m not sure anything can…
Where are you getting this binary idea from? While there may be times where a single event with two outcomes will drastically affect a stock price, there’s plenty of instances where opinion can vary widely on a continuum. I’m particularly baffled because the paper I referenced doesn’t include the word “binary” and instead looks at multiple forecasts (where available, which is uncommon except for large companies) and volatility and volume as proxies for dispersion of evaluation.
Or to use a recent, prominent example, was Overstock.com a binary stock, to use your terminology? Unless you want to count the binary event as going bankrupt, I’d argue that it was tremendously overvalued and the people shorting the crap out of it were motivated by its terrible fundamentals, not that there was any single event that would result in divergent outcomes.
The point of the paper was that when dispersion is high and shorting is restricted, equities can be overvalued as much as 20%. That’s huge! That kind of market distortion is an issue worth addressing.
Well, the split of short and long positions held will depend on the particular strategy used and it varies a lot. By definition neutral strategies have a 50/50 split, a 130/30 will have 130 long to every 30 short, etc. Obviously it will vary with the market but if were to pull a number out of my ass I’d say … 35% on average will be short positions? But while those positions are directional shorts in the sense they are not pure hedges in the sense of futures contracts or classic industry specific hedges (long GM, short Ford) they still act as hedges against market risk.
I’d agree that the positions are not always industry hedges, or sector, or geographic hedges, etc, but overall the short position hedges market risk, replacing it with manager risk i.e. the risk that the guy you pay to pick is better than his colleagues. I’d argue that’s distinct from dedicated short positions, and that they are using shorts differently.
But to get back to the orginal issue (I think?), I like long-short funds because as an investor, they a) might make me more money than a dedicated long fund, and b) limit my market risk. I don’t think I’m alone in this. What do you feel are the downsides of short selling that would warrant restricting this option?
You referenced the following: “I can think of case where there were the short interst was several times the float so an investor bought the float and requested physical delivery. He held certificates for the entire float and the stock continued to trade several times the flioat over the next few weeks. Another time a company plagued by shortselling repurchased their entire float but the trading in the stock simply continued.” I don’t doubt that can happen, but I’d be curious to know what companies these were? It’s not like it’s a trade secret or anything. Many people would argue that every time someone is complaining about short sellers’ manipulation, there’s someone trying to divert attention from something else, again, reference Overstock.com. Now that they are actually turning a profit their share price is looking more reasonable, but it’s nowhere near the heights it hit when allegations of naked short manipulation were flying. If these companies were destined to fail, why is short selling them into the ground a bad thing?
Perhaps that was a bad analogy. But the correct price of a stock is not the weighted average of the value of the people who have an opinion of the stock’s value. Imagine a world with only ten investors and three shares of stock. At a moment in time, 3 investors think the stock is worth $5, 4 investors think its worth $10 and 3 investors think its worth $15. The stock is owned by three of the investors who think its worth $15 (stock is almost always held by the people put the highest value on the stock). Why should we permit one of the investors who think its worth $5 to create synthetic shares to sell to the investors who think the stock is worth $10 and perhaps even to other investors who think it is worth $5?
So then we are just concerned with “price discovery”? It is so important that a stock be priced at $40 instead of $50 (when there are enough buyers at the $50 to absorb the entire float at that price) that we open the door to the abuses that shorting can lead to?
Sorry I picked up the binary stuff from your example upthread, lets move to high dispersion.
I didn’t read the article as carefully as i might have but from what I kenned it sounded like they were basing their conclusion about overvaluation based on sstock performance of these stocks compared to the overall market.
I am not surprised by the fact that a stock that some people think is so overpriced that they are willing to pay to maintain a short position underperforms the market.
Like I said, these folks aren’t hedging market risk except as a by product of their primary focus, stockpicking (or industry picking).
I don’t think these folks are strategically shorting stocks to somehow hedge market risks. They are shorting stocks they think will go down. Sure I guess you can say that almost any short position hedges almost any long position to the extent that the entire market may move in one direction or the other but that is hardly why they are doing it.
TAANSTAFL. A long short fund might offer different returns than a long only fund but it doesn’t offer better returns except by happenstance.
Short selling creates shares that didn’t exist before the short sale occurred. This provides opportunities for abuse and manipulation. Low stock prices are very sticky. If you flood the market with enough artificial shares of stock, the stock price will drop down and stay down. At least long enough for you to exit your position at the lower stock price. Higher stock prices are not quite as sticky because you are dealing with a limited universe of shares so stock prices do not stay up while you exit your position if you have cornered the market..
The thing is these companies are not destined to fail, merely likely to fail. Lehman did not have to fail overnight. In the absence of shorting Lehman might have been able to cobble together some sort of deal with a white knight or even raised additional capital but in Lehman’s case, shorting became a bit of a self fulfilling prophecy.
You seem to believe that long-short funds are simply picked individually to maximize value. I strongly disagree that this applies in most cases. Obviously they pick long stocks they think will go up and short stocks they will go down. That’s true regardless of your overall strategy. But in general you want overall portfolio balance that, while it may shift according to market conditions, has some overarching strategy, taking a long bias in general with shifts towards a short bias in bear markets. I’d argue that the long-short ratio of any particular fund guides the equities selected to some degree, as opposed to the ratio being a result of trying to maximize added value.
By your standards, I could make my own long-short fund by buying a 50-50 ratio of a quality long term equity fund and my favorite dedicated short bias fund. I mean, presumably each manager would have an advantage of focusing on one type of equity right? And this way the long manager doesn’t have to deal with the added overhead associated with short selling. And in a sense I’d hedge some market risk. But I want my manager to do more than that. I’m still exposed to all the stock-specific risks in each portfolio and if I don’t have an overall strategy I’m also exposed to more market risk than I need to be. A single manager picking both should be able address both with intelligent strategy.
I would agree that anyone who chooses to invest long-short specifically, and in hedge funds generally, would anticipate lower returns in a bull market and higher returns in a bear market when compared to an index fund. Investing in a hedge fund to improve your return over market in general is a suckers game. But I contend that if I am restricted to holding long only I’m totally exposed to bear markets no matter how brilliant I am at picking stocks.
Yes, we all know the mechanics but I was asking for actual evidence this happens. Typical short selling requires borrowing or otherwise securing the share first. You keep positing this hypothetical scenario, and I asked you to give names for the examples you described where companies were being naked shorted illegally. In fact, you seem to be claiming that hedge funds routinely do this.
The example you did provide, Lehman Brothers, seems an odd example to pick. There were excellent reasons to short Lehman’s stock and for them to go bankrupt. While there was an increase in FTDs a) this is not surprising because everyone and their mother was trying to short them b) even if all 33 million of the FTD associated with their demise were actual, illegal naked shorts that’s against a float of 688 million. Do you think that it was shorting 5% of a their stock that caused their bankruptcy? Or might the fact that they sustained huge losses, were heavily leveraged, and had over half a trillion in debt have something to do with it? The SEC seems to think its the latter. It’s been 3 years, it’s not like we haven’t had time to unravel this.
For those following along I believe Damuri is contending that though naked shorts are illegal, parties still engage in functional shorting by not actually borrowing equities before selling, claiming they will obtain it in short order while not actually intending to do so. Typical short selling does not create virtual shares. Naked shorting and functional shorting do. All drive down prices. Accusations of naked shorting are common claim but many, many people think its bull. I’d like to see some evidence this actually occurs. A specific example would be nice.
In a long-short/pair/stat arb strategy, it isn’t necessary that the short leg of the pair go down for the trade to make money. The purpose of the trade is to profit from the relative under/over performance of one instrument relative to another. If a person is long ABC and short XYZ at a price ratio of 1.0, they’d want to see ABC outperform XYZ. As long as ABC/XYZ > 1.0 when the trade is exited the trade will be profitable. It doesn’t matter if the ratio moved due to a change in the numerator or denominator.
Are you saying that hedge funds generally do things like go long Ford and short GM. Because I thought we had taht discussion a little bit upthread and noone objected to my statement that this is not the case. That hedge funds are more likely to go long companies they like and short companies they do not like. Sure there will be some natural hedging from broad market movements but its not teh sort of hedging that I think you are talking about.
I don’t think I’m saying that. I’m saying that they aren’t pairing off their long and short positions. Their overall long short ratio is an overall market outlook like when Merril tells me to go 50% equity and 50% debt. I’m sure they keep an eye on overall portfolio balance (if thats important to them) but I don’t think they are pairing off their stocks. Noone is putting their money with a hedge fund because of their ability to pair off stocks.
Yeah, I don’t think they do a lot of that.
I agree but your statement made it seem like you thought that hedged positions would produce higher returns than unhedged positions.
I don’t think most hedge funds engage in this sort of behaviour but some do. Its one thing when you have companies pop up on the fail to deliver list from time to time, its another thing when there are comapnies that stay on teh Reg SHO list for months and years.
You asked what harm shorting does and i was presenting an example of the harm not of illegal short selling. In the absence of short selling Lehman may have gone bankrupt anyway but they might also have been purchased or raised capital or have found some other way to ride out the iliquidity in the market.
This is not exactly what I am saying. I am not railing against naked short selling although I think it exists, I am asking why we permit any short selling whatsoever. EVERY short sale creates a virtual share. If there was only one share of stock ina company and I borrowed it from Peter to sell it to paul there are now two people who have had their demand for that share satisfied there are now two shares where once there was one.
It’s only a benefit if multiplied by -1. It’s not like there aren’t other mechanisms to use for investing in businesses and it’s not like in it’s current form it’s helping poor business owners overcome not having political or financial connections. Te stock market is just part of the real world government, the plutocracy. Don’t run your business the way they see fit and say hello to bankruptcy. The same can be said for money markets and national governments.
You keep using terminology is odd ways. What is a hedge if not accepting lower returns to exchange for reduced risk? A hedged position will produce lower returns in general but higher returns if the risk comes to fruition. A long-short fund generally produces lower returns in your typical bull market, but higher ones in a bear market. That’s… hedging market risk.
This isn’t the 1940’s, they don’t make literal pairs of trades 1:1. If nothing else this ties you to 50:50 long short split. But the idea that they just pick long positions they think will go up and short positions they think will go down is flat wrong.
One last try at this: Let’s look at Warren Buffet’s long bet with Protege. For those unfamiliar with this bet, Buffet bet essentially a million dollars that an SP500 index would produce higher returns than a cherry picked basket of hedge funds over 10 years. That’s a pretty bold claim, as Protege is a highly regarded firm and their managers have a proven track record of picking winners. Let’s look at Protege’s position statement:
“Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional “relative-return” investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.”
Pretty straightforward, right? Since they made their bet in 2007, Buffet got creamed in the bear market of 2008. The SP500 lost a whopping 37%, whereas Protoge’s funds lost only 24%. In the next two years, SP beat Protege 26% to 16% and 15% to 8%. So why do you think that is? Why are Protege’s returns so lousy for these last two years? Are they such lousy pickers they can’t pick long equities to at least match the SP500? Or do you think it’s the short positions they hold? The short positions that are hindering their returns in the last two years but protected them in 2008? It’s not as though they made a few bad bets-last year their short portfolio halved their performance compared to the SP500. They are clearly not just shorting stocks they think will go down, to use your terms. If they are they’re are doing a really lousy job. They are hedging market risk. And for a sophisticated group like Protege they are doubtless hedging various other risks too.
Like I said, give some examples. And if people are naked shorting a company for years, you’d someone would notice. It is illegal after all.
That’s ridiculous. Lehman had extensive accounting irregularities and portfolio loaded with terrible debt. Short selling didn’t cause their multibillion dollar losses. Short selling didn’t cause them to be over leveraged. In the summer of 2008 they had 200 million in reserve against 6.5 billion in CDO exposure. Barklay’s didn’t pass on LB because their stock price was low. (Remind me again why declining stock prices makes a buyout less likely) Einhorn, among others, was shorting LB as far back as 2007 and made multiple public statements about exactly why he was doing so. If LB had actually paid attention to the shorts and recapitalized in 2007 they may have survived. People were shorting LB because they thought, correctly, that they serious problems. By 2008 when they failed, they richly deserved it. The government didn’t intercede, rightly or wrongly, because LB had no collateral and was unlikely to pay back their loans, not because their stock price was in the toilet.
Sheesh, if you start using the term virtual share in reference to short selling and naked short selling, don’t act confused when people assume you are talking about naked shorting. In typical shorting, the share is not “virtual” and to refer to it as such is confusing as hell. You are borrowing an actual share. The party you are borrowing it from collects borrowing costs but if the price drops they take a loss. You are, however, correct in that shorting will increase supply and thereby reduce prices. But who cares? You don’t make any money unless you can convince others that you are right and the price continues to fall. If they think you are wrong, they buy the now undervalued stock and squeeze you. I recall someone published a short thesis on Berkshire Hathaway that resulted in a slight dip in its price, which quickly corrected. Presumably some shorts got nailed by that one.
Again, please provide examples of actual stock manipulation. There’s irregularities to be sure, especially as you get down to the penny stocks, but I’ll take whatever you’ve got. If you aren’t bothered by stocks being up to 20% overvalued, I’m not going to be bothered by stocks being undervalued by the the same margin. In fact I’d love it if that happened routinely. Great opportunity to buy.
Truth is if you’re not insider trading you’re just playing against the house, and while you may get lucky and win the house always beats the crowd, stock trading is absolutely stupid and harms society. You don’t want your smartest kids going off to figure out how to gamble well. You want them to be doctors scientists engineers and such. Real value comes from real work.
We’re not going to agree. I don’t think shorting provides enough benefit to justify the practice, you disagree. I don’t think most hedge funds engage in shady shorting but I don’t think that most of them do what you say they are doing. I don’t see the long short ratio as much different than a funds decision to hold 50% debt and 50% equity depending on the environment. I’ve never said that every or even most shorts are abusive but some are and thats enough for me to ask why we permit it and I don’t see the benefit. I don’t think the paper you cite is analytically sound because it doesn’t take into account the fact that shorts are picking overvalued stocks to the point where it becomes hard to borrow rather than the hard to borrow status being the cause of the overvaluation. Sure being able to short stocks generally probably leads to higher prices but i think the underperformance is not encessarily due to the unshortability.
Have you ever taken a look at the reg sho list?
I never said Lehman deserved to survive, I am saying that shroting accelerated their demise where there might have beena chance that they would have survived.