From the November 01, 2008 issue of Futures Magazine • Subscribe!

Sold short

It’s Monday Sept. 22. The week before, Lehman Brothers shocked the financial world by declaring bankruptcy and sent the markets into an epileptic siezure. But for me and the hedge fund I work for, things couldn’t be better. Volatility is on the rise and the atmosphere is just right for high frequency trading strategies like ours. Shortly after the 9:30 open, our broker calls me inquiring about a certain short position in a retail banking company. “It looks like you are going to need to close it,” I am told. The stock is trading in its teens, the BID/ASK spread is several dollars. “You can’t be serious,” I reply. “The spread is more than 30% and there haven’t been any trades on it.” The broker tells me he’ll get back to me. About half an hour later I get a callback. “The position must be closed today, pay any spread you have to.” I am shocked. But my position is not a big one. I pay the spread and close the position, creating a two months high in the process, and book a loss. All things considered I am pretty lucky. If I had to close a bigger position I would have ended up paying a 700% spread.

The previous Thursday the SEC passed a rule banning short selling on 799 financial companies. When I first heard about the rule, I figured that the SEC wanted to ban any new short sales in these companies. But no. The SEC stated that almost no one could have positions in these 799 companies. This was the reason why the Dow shot up more than 300 points the following Friday, as everyone was scrambling to close their short positions. Hedge funds and proprietary trading desks were losing a lot of money on carefully crafted positions that were designed to earn them a stable return of just pennies a share.

As we all know, panic in the financial sector was causing markets to take a turn for the worse in mid-September and regulators needed an easy short-term scapegoat. It wasn’t going to be the mortgage borrowers, who took out loans that they could only repay, if, as they expected, real estate prices continued an infinite climb higher. It wasn’t going to be the banks, whose risk models apparently used the same rosy scenario on home values. And it certainly wasn’t going to be government agencies and congressional committees whose job it was to oversee the banking and lending sectors and pass regulations to prevent the very mess we found ourselves in.

Instead, the SEC picked on the group that no one completely understood or particularly wanted to associate with, the short sellers. Within hours of deliberation, the SEC passed a rule so grotesque, so unreasonable and so anti-market efficiency that I heard reports out of Moscow that Lenin actually smiled, and in Scotland a statue of Adam Smith shed a tear.

Making matters worse was that the rule change went into affect the same day, so no one has a chance to adjust their strategies.

So did the short-selling ban really solve anything? A week after it went into effect, Washington Mutual handed over most of its assets to JP Morgan, and the bank stopped trading on the NYSE. Unable to short financial companies, traders and investors who wanted to protect themselves from a bear market were forced to short other companies and sectors, unfairly causing those stocks to go down, and adding more inefficiency to an already chaotic market. But, the worst thing to come out of this whole mess is that investors and traders will from now on be more hesitant to participate in the activities of a financial system whose rules and stability can be undermined by just a few individuals.

The SEC solemnly stated earlier this year an investigation of short sellers to root out potential market manipulation. It is amazing that they don’t seem to realize that they have been the ones manipulating the market.

Gennady Favel is the head of equity trading for an algorithm driven hedge fund and the author of a recently published book, “The Stock Market Philosopher. “

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