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Some implications of the new short rules

September 19th, 2008 · No Comments

We try to make sense of them..

Shorting shares is borrowing shares from some counter party, selling them, buying them back (ideally more cheaply), and delivering them back to the lender, pocketing the difference (minus interest rate expenses for the borrowing.

Naked shorting is the same process, without first borrowing the shares. This could lead to delivery problems.

The new rules limit naked shorting to 3 days, shares will have to be delivered, that is, the shares that were sold short have to be borrowed from someone, within 3 days after selling them. No exceptions, not even for options market makers.

Some consequences.

  1. Intra-day volatility. Shorts might sell into buying to keep the stock from going higher, but they will have to deliver these shares within days. It’s also been made a criminal offence lying to the broker on the ability to borrow shares, so we’ll see short cycles of shorting and covering, intra-day and a couple of days at most.
  2. Shorting has become both more difficult and more expensive. More difficult because of the new rules on naked shorting, which will shift ‘demand’ to normal shorting. However, access to borrowing shares is very limited because IOC is already heavily shorted and there are 3.6M nakedly shorted shares that have to be located sooner rather than later, shorting will become much more difficult and costly (naked shorting is interest free, normal shorting isn’t, and the demand for the latter has gone up because restrictions on the former have increased considerably).
  3. No easy exit via the options market. One of the things that thrilled us most was the end of the exemption for options market makers from the 3 days delivery limit. You can see the effect on the dramatic increase in the spread between bid and ask.
  4. Short cover rally? With their ability to fight a rally much diminished, it will only take one trigger to tip the shorts over the edge. If the price goes up and they can’t stop it anymore, they will need to cover, joining the buying.

The upshot. The landscape really has changed, they can keep it down for a little bit, but within days, they have to locate shares, which will be very difficult and costly, and hence serve as a deterrent to shorting. All this will lead to much more intra-day and inter-day volatility, but the trend will be up because:

  • Outstanding delivery problems will have to be delivered sooner or later
  • Shorting InterOil has become more difficult and expensive

One outstanding question: with about 3.6M shares with delivery problems already outstanding, how strict will the SEC be in enforcing delivery? If they are strict, that in itself might trigger a short cover rally. We think they will concentrate on the financial sector first, but we’re pretty sure sooner rather than later, something needs to be done about this, as it’s basically illegal.

Tags: IOC · The Markets