Friday, July 18, 2008

Shorts

Akin to speculators are the short sellers - people who short the market, i.e. bet that the price of a stock or a commodity will go down. The normal way it works, in a nutshell, is this: a trader who believes the price of a financial instrument will go down will borrow shares from his broker and sell them on the open market with a promise to repay the broker those shares within a certain period. If the price does indeed go down, he then buys back the shares at the current price and returns the shares to his broker. The difference between what he sold them for and what he repurchased them for is his profit. To put numbers to this, say I borrow 100 shares of ABC corporation and sell them for $100 per share. I now have $10,000. Two weeks later the price of ABC has dropped to $92.50. I repurchase all 100 shares at that price for $9,250 and return the shares to my broker. I've made a profit of $750.

Of course, if I'm wrong I'll get burned. Say the price of ABC stock goes up to $110 per share. I must still cover and return the shares to my broker. In this case I've lost $1000 ($10,000 I received when I borrowed and sold vs. the $11,000 I had to pay to cover, i.e. repurchase the shares to return to my broker.)

The SEC moved to limit naked shorting against the financial sector the other day. Naked shorting is the practice of selling shares without borrowing them first. I don't really have a problem with this, though I don't know enough about it to be sure. In what is probably a first for this blog, I'll state that on this issue I may change my mind once I've learned more about the practice.

But my real concern in this post is normal shorting, and with this I have no problem whatsoever and neither should anyone else. Shorters get a bad rap but they perform an important function in money and commodity markets. As Jerry Bowyer pointed out the other day on Kudlow's show, short sellers are (I paraphrase) the market disciplinarians, the ones who say, "no, I don't believe this story." They are the market pessimists, often the market realists, and they keep stocks and commodity prices from exploding irrationally to the upside. They have been blamed for the crash of the financial stocks but they've been correct in their analysis - the balance sheets of many financial companies, even in good times, are baroque works of fiction that are not understood even by company insiders. So complex are the assets these firms hold that putting a value on them is akin to throwing a dart blindfolded. It is natural for executives to be, shall we say, optimistic when assigning those values. When the subprime crisis arrived last fall, the shorts were the ones who understood this first. They made money of the trade because they were right. More power to them.

Anyhow, the Wall Street Journal has a nice column this morning on the recent SEC decision. It's well worth reading in full. The point is, people who speculate on oil are not evil, nor are people who short the market. They both perform important functions. Blaming all our current woes on them is an prerogative only for politicians and other ignorant people.

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