Selling stock short shouldn't get blame for a precipitous decline
By Gregory M. Drahuschak
FOR THE TRIBUNE-REVIEW
Sunday, April 30, 2006
Occasionally, firms whose stocks have had precipitous declines blame the stocks' misfortunes on short sellers who the companies claim purposely drove the price of their stocks lower. This point was raised during a recent Enron-related trial.
Short selling has been around for decades and is a viable tool when used correctly. Allegations about what is called "naked short selling," however, suggest that rules are circumvented in an effort to drive a stock down.
Someone who believes the price of a stock will fall can sell the stock. Their profit or loss becomes the difference between their sale price and purchase price. A short seller profits from a decline in a share price while a buyer benefits when the stock goes up. The differentiation between an actual owner and a short seller is that they do their transactions in reverse -- a short seller sells first and buys later while a normal share owner buys and then sells. A short seller, however, does not have shares to deliver to a buyer. In order to do so, a short seller must borrow shares from someone.
Major brokerage firms holding millions of shares in margin accounts often can accommodate short sale transactions by lending shares from their own inventory or from individual margin accounts. A short seller can then choose when to close out the trade by buying the stock in the open market and delivering those shares to the lender.
"Naked shorts" occur when shares are not borrowed to make delivery. If continued unchecked, the process could drive the price of a stock notably lower since there would be no offsetting checks and balances. It is worth noting, however, that a short seller runs the risk of losing more than his original investment whereas a non-margined buyer's total loss potential is limited to the amount invested.
The key in this process is the ability to borrow shares. In order to protect everyone, firms require that shares that can be borrowed must be available before a short sale is executed. If, due to a clerical error or merely an oversight by the selling broker, a short sale is executed without getting prior acknowledgment that shares can be borrowed, an internal reconciliation process usually catches the error soon after the trade is executed.
Assuming, however, that someone is able to get beyond the borrowing requirement, specific trading rules would further inhibit naked short selling.
This topic is not new.Allegations that short selling has been the main factor driving a stock lower have been around for years. Interestingly, when you look back at many situations where this activity was alleged, you find an uncanny corollary with rapidly deteriorating fundamentals in the stock. A coincidence? Maybe, but probably not.
Anyone who has been in the securities industry for a significant number of years can tell you that regulations today are far more stringent than ever. The liability to individuals and their firms is too great to attempt to circumvent trading regulations, especially ones like those related to short selling, since there are numerous ways either the firms themselves or the regulatory agencies can catch them.
Exchange Traded Funds, or ETFs, are exempted from some short-selling trading regulations, but there is a misconception that the borrowing rules do not apply, either. They do.
Short selling usually is not something for the typical investor. By definition, it often is in conflict with most people's long-term investment goals.
Short selling, however, can be a useful but temporary tool. It, however, is not a tool to be wielded without fully understanding regulations and practices.
It also is not the whipping boy excuse for every stock that experiences a sharp decline.
Those reasons most often are found in a balance sheet or income statement.
Gregory M. Drahuschak is first vice president of Janney Montgomery Scott Inc., Pittsburgh. |
