Is There a More Efficient Shorting Tactic?

The recent SEC curbs on shorting a select list of financial stocks got me thinking about ways to avoid these silly procedural rules. I was short some of these financials, and in deciding whether or not to cover, I had to also consider the fact that I would likely be unable to short the stock again.

I called my broker, and they confirmed my suspicion: there was no stock available for shorting--for the time being. I asked whether it was likely that my short position might get called away--that is, that I might be forced to cover: highly unlikely, was the answer. I described my predicament (a juxtaposition of fear against greed), that I wanted to cover (fear), and still keep the borrowed shares around for shorting later (greed), and they said there would be no guarantee that there'd be any more shares to short after I had covered.

How about if I bought the stock in my long account, didn't touch my short account, and later sold the shares in the long side of my account? I suggested. Can't do that either, they said. Once I bought the shares on the long side, they would be in a boxed position, and I would not be able to sell any more shares. I thanked the broker and hung up.

The solution to my problem had already presented itself in that last question. All I had to do was to go long the shares in another account I own at another broker: the combined account positions could exactly offset each other, and I would be able to later return to a net short position simply by selling the shares in the long account at the other broker.

I doubt the procedure described here is illegal, [Ignorantia juris non excusat warning and other usual IANAL, IANAIA disclaimers go here], and if it is, I certainly couldn't find anything about it on the web. (Truth be told, I didn't ask either of my brokers: I had heard enough stupid "No"s for one day.)

My solution to this short term problem, created by a seemingly capricious regulator, led me to consider its more general application. For the regulator, by making shorting difficult, has created artificial scarcity. A short position, then, by virtue of its scarcity, must have more value than its nominal value. How much more?

Let's call this double account tactic, where your long shares in one account are exactly offset by your short shares in another account, an open boxed position. I suggest the scarcity value of a short position might somehow be connected to the cost of money (e.g. as employed in the Black-Scholes model) required to maintain an open boxed position in the same number of shares. I say "somehow", because while I can easily quantify how much it's currently costing me to maintain my open box, there is no general way to determine what it might cost another person (the cost of borrowing shares varies from broker to broker).

To put it another way, I suggest an open boxed position is a store of all the regulatory overhead associated with shorting. A speculator wishing to short hard-to-borrow shares, must consider both price movement and the availability of shares to short in the timing of their trade. It is a well known fact that open interest tends to increase at price peaks, making shorting at the best price a double challenge.

This puts the short trader at a tactical disadvantage to the long trader. In order to mitigate that disadvantage, a speculator who plans to short shares at, for example, some future higher price might build a (net neutral) open boxed position, to be unboxed (net short) at a future time when the price or trend is right. In building the open box position, you are satisfying all the regulatory overhead of shorting ahead of time (whether that overhead is the requirement that your short never be naked, the now defunct up-tick rule, or some other silly red tape impeding your ability to short at the precise time of your choosing). Alternatively, as described at the beginning of this post, a short position can evolve into an open boxed position.

That you can easily skirt the intent, if not the letter, of regulatory restrictions designed to impede shorting is a testament to the fact that shorting is a natural, organic outgrowth of market activity. It is not an activity born of the invention of some new fangled derivatives instrument; rather, people have been shorting stuff for centuries. So I guess it shouldn't surprise us if we later find that the new SEC curbs on shorting only worked temporarily. The market always finds ways to correct artificial scarcity.

Stock Position: Short.

Comments

[lorange]

Interesting, but on a more fundamental level it's curious why any institution or large holder would lend the stocks of these companies at all. Sure they make pennies lending while losing huge $ as the shorts crush the stocks in what has been a can't lose one way trade for a year

[jlounsbury59]

lorange - - -

What you say is true if the shorted stock stays down. But look at the money made when the shorts get crushed on the rebound. Good example is BAC in the past few days.

The large or institutional holder can hedge their downside risk with options (as can anyone, but smaller holders often do not hedge). Bottom line, institutions would not be lending to shorts if they were not making money.

[Yomgui]

The simpler way to short one of those financial stocks is to buy a put option.
Even for 'Sec restricted' financial stocks you can easily buy a deeply in the money put. The P'n'L from that position will very closely mimick a short sale.

[glassbox]

jlounsbury59, its true institutional holders might just be making money lending to shorts. I think however, there has to be expressed disclosure as to how much they or the fund that they manage are making on this lending. I don't know what is the practise but knowing the soft dollar arrangements that can potentially exist, its important that lending institutions disclose how much they make from lending the stock and how much of that goes to the fund.

[jjason]

The solution to your problem would be to make all short selling illegal.

[Owen]

The Put-Call Parity ensures that buying a Put and selling a call, both with the same strike and expiration, is identical to shorting the underlying stock. In practice, the same result is achieved by buying a deep in-the-money Put, as Yomgiu mentions, or Writing a (naked) deep in-the-money Call.

Another method of achieving the same result is by selling the corresponding Single-Stock-Futures contract. SSFs are now available for most S&P-500 stocks, with the contract size of 100 shares aimed at small traders. Liquidity isn't as good as for stocks or options, but none of the arbitrary limitations apply to futures or to options, and margin is more reasonable.

Traders will always find a way around regulations to implement profitable trading strategies, albeit incurring higher frictional costs. The only benefactors from rules such as the uptick, ban on naked shorting and others limiting free market trading are the middlemen, in this case options and futures market makers and arbitrageurs.

[Owen]

Oops--I meant _Yomgui_.

[Stephjen]

i wouldn't be short one of those 20 financials now because the squeeze (mostly already happened over past few days) has been huge as naked positions have been covered.

[User 93139]

Buying a deep in the money put does not have the same delta as shorting the underlying stock,therefore not the same.

[Owen]

User 93139: A deep in the money Put will have a delta close to -1, and a gamma and theta of almost zero. So while not theoretically identical, it's close enough for any practical purpose. For example, the FNM-Sep-50-Put has a delta of -0.95 and gamma of less than 0.01. So if, instead of shorting 2000 shares of FNM you buy 21 of these Put contracts, your P/L function will be within pennies of what it would be with the underlying.

[Yomgui]

Thanks Owen for the detailed discussion of how to short via options or futures.
As a conclusion it is obvious that the SEC rule is not effective to curb short selling. Other methods are readily available to profit from a decline in share price (options, futures).
So what are the benefits for the SEC of issuing such a rule ?
- Psychological impact on the market (it seems to work well).
- Need to 'look good' politically to the general public, who doens't like the idea of banks going bankrupt because of alleged short seller manipulation.