The Value of Short Sellers
Monday, October 23, 2006
by Jeff Neal of Optionetics.com
Short selling plays an integral part in the markets and short side investors provide liquidity to the stock market. However, in general short sellers are looked down upon even though they are necessary. But more than just providing liquidity, short sellers have uncovered not only overpriced companies but also major financial fraud. Despite the usefulness of short selling, sellers are still burdened by regulations, which include the uptick rule that prohibits sales when the price of the stock is in decline.
Some of these strict rules as they relate to short selling might start to change. For instance, recently the Securities and Exchange Commission concluded a pilot program to suspend the uptick rule for a third of the stocks in the Russell 3000 index (RUA) and compare their performance to stocks that still had this rule apply. The conclusion by leading economists was that this price restriction on short selling was a regulation of no benefit to the market. Essentially, equities that were free from the uptick mandate showed no more impact to momentum selling than the group that had the uptick rule in place.
On the other hand, when it came to the "pump and dump" scheme they all agreed regulations needed to remain in place. The pump and dump scheme is where someone promotes a worthless stock they own and then sells it as gullible investors fall victim to the promotion. The economists and panelists involved in the study all agreed that these schemes are still common within the marketplace, especially with small-cap stocks and the prevalence of spam e-mail messages.
Ironically though, it has been shown that the primary defense against such schemes comes from short sellers instead of the often slow moving Securities and Exchange Commission. The reason, experts point out, is that the short sellers are the only market participants who are right there, since there is an incentive by that group to burst bubbles and disseminate discouraging information. In fact, a Securities and Exchange Commission lawyer noted that short sellers are responsible for early warnings on certain companies that subsequently led to the capture and return to investors funds taken by stock frauds.
The Securities and Exchange Commission has not returned any favors to the short selling community. Not only has the agency burdened short sellers with strict trading rules but they also have virtually ignored it when companies have taken potentially illegal actions to quell short sellers' criticism. For example, the Securities and Exchange Commission has been more than ready to investigate short sellers based on complaints from other firms that the short sellers have said bad things about them.
Given all the good things short sellers do, not only for liquidity in the marketplace but also helping the Securities and Exchange Commission, they also protect the public from stock fraud schemes, so one would think the public would be more grateful. Maybe a few more market studies showing that short selling is not harmful and overall sentiment might finally change at the Securities and Exchange Commission.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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Short Sellers, Securities and Exchange Commission, Liquidity, Russell 3000 Index RUA
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