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Trader's Corner

Short Selling and Puts

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OIN SUBSCRIBER QUESTION:
9/29/08: "What effect, do you think, has the limitation of short sales on your sentiment indicator that is based on equity only calls to puts? I have found it a very useful indicator in timing my trades."

RESPONSE:
I certainly agree and have found the ratio of daily equities-only call to put volume to be highly useful in timing my trades. Especially in that I tend to trade somewhat infrequently by waiting only for extreme market situations; i.e., overbought and oversold extremes, including extremes of bullishness and bearishness.

As an 'indicator', as a chart, allowing an analysis of the call/put volume over time compared to price activity, it's very useful as it taking out INDEX option volume from this ratio, which reflects significant market hedging.

On your question, prohibition of short sales in certain sectors of the market might increase put volume beyond normal speculative and hedge activity but it's not clear that it does. More on that, but I'll first say a bit about on the current short-selling limitation.

THE SHORT-SELLING BAN
Speculative shorting of a stock is of course making a bet that a stock's price will fall. An order to sell short requires that the transaction can only be done on an 'uptick', requiring that the sell may only be done if the price is above the prior reported sale. The shares are 'borrowed' in order to sell what you don't own. If the price falls, or not, a short seller has to eventually buy the actual shares to 'cover' the stock 'short' in their account. 'Naked' short selling is when sellers don't even borrow the shares before selling them. The SEC now order requires short sellers to actually borrow shares before selling them.

Analysts and government regulators blamed aggressive short selling for exacerbating the plunge in Fannie Mae and Freddie Mac's stock, as well as that of Lehman Brothers and put an emergency order into effect on July 15 after a major decline in Fannie and Freddie. The Securities and Exchange Commission (SEC) emergency order baned short sales in FINANCIAL stocks, saying the changes were needed to ensure the continued smooth operation of orderly markets. Their order was extended late last month.

The SEC kept in place an exception to the short-selling ban for bona fide market making in derivatives of any of the 799 targeted stocks. There are certain short-sale exceptions for NYSE market makers, where most if not all of the financial stocks in question are traded. These relate to keeping an 'orderly' market, such as in periods when there are large order imbalances; e.g., on the open, large unfilled buy orders in a stock and the market maker for that stock sells borrowed shares to those buyers and covers his short position later. (A market maker may sometimes buy puts when going short to hedge against a steep decline in the stock they are short.)

The SEC modified the aforementioned exception recently so that for new positions, market makers may not sell short if they 'know' a customer or counterparty is increasing an economic net short position in the shares of that stock. This would seem to put a lot of responsibility on the market maker to know this, but it's not out of line with the basic charge to basically know the counterparty to your trade.

The SEC ban on short selling includes banks, savings associations, broker-dealers, investment advisors, and insurance companies, whether domestic or foreign, and the owners of any of these entities. These companies can opt out by notifying the exchange to exclude their securities from their list.

SEC Chairman Christopher Cox said the order was helping prevent potential "distort and short" manipulation of stocks, which occurs when rumors and misinformation are used to drive down the price of a stock that has been shorted. In addition to continuing the earlier order against naked short selling, the SEC is going to explore other remedies for the broader marketplace to further protect investors from 'distort and short' artists according to SEC chairman Cox.
After the ban runs out, regulators are supposed to draw up formal rules to provide additional protections against abusive naked short selling in the broader market, while allowing 'legitimate' short selling.

NO SHORTING RULE AND INCREASED OPTION ACTIVITY
Back to the question about how the limitation on shorting some stocks might impact equities option trading. The financial stocks make up a significant portion of the S&P index.

Who shorts stocks to begin with and how big an impact it shorting anyway?

Short sales in recent years have represented as much as a quarter of NYSE average daily volume and around 30 percent of Nasdaq share volume. There is shorting related to market making and pertains mostly to providing liquidity and there is of course opportunistic risk taking by short-sellers.

Given the cost of short-selling, the bulk of short-sellers are predominantly institutional traders. For example, one study found that about 75 percent of all short-sales are executed by institutions, while individuals represent less than 2 percent, with the rest specialists and some other small categories. Since many institutions are prevented from shorting (e.g., many mutual funds), the ones that use short-selling as part of their strategy tend to be more sophisticated. You have to assume that short-sellers as a group are likely to be sophisticated traders.

ALTERNATIVES TO SHORTING
1.) Buying puts of course, but this can be costly in times of high volatility where put premiums escalate
2.) Synthetic short sales; i.e., long put and short call

Shorting calls is not really co-equal to the two alternatives to shorting, but does provide some downside participation to the extent of the premium taken in.

Since we're trying to figure if the prohibition on shorting will distort our call to put volume ratios, we can rule out a synthetic short position as the calls and puts will be in balance there. This leaves the potential that we see put volume increases that are solely related to institutions buying puts on stocks that they can't short.

My assumption is that call-to-put ratios are NOT being distorted much at all or not overly much. If they were, I would expect a sizable jump in put volume on big down days and this in fact was NOT seen on the major decline on Monday. I commented on this in a Monday Trader's Corner article and took this as an apparent LACK of 'capitulation', leading me to anticipate further declines such as today, as traders on Monday figured that a bottom wasn't far off.

Assuming short-sellers are heavily institutional, they are not going to be able to get off anything equivalent to large short positions by going into puts. Executing a 50,000-share short position in a big financial stock isn't that difficult in the right market conditions; e.g., on a day where there is at least some buying interest due to the 'uptick' rule. Getting off an order for 500 puts in the same stock, without a huge jump in the option price, presents a much higher degree of difficulty.

The chart of the S&P 100 (OEX) here has a downtrend channel highlighted that reflects my take on the parameters of the ups and downs of the current downtrend. My CPRATIO 'sentiment' indicator displayed below the OEX chart reflects overall market 'sentiment' and doesn't just pertain to the big cap S&P stocks.

The 'sentiment' indicator I've been discussing above has two key days highlighted this week as to the call to put volume ratios. The huge down day on Monday (see the sideways pointing blue arrow) saw CBOE equities call to put volume at 1.3; i.e., total call volume was 1.3 times that of put volume. If the absence of the ability to short financial stocks was driving up put volume it wasn't reflected here, as a 1.3 call/put reading doesn't reflect a highly bearish trading stance. 1.1 and under, such as the reading at the green up arrow at .87 does.

Today's decline saw a fall in my sentiment indicator to 1.12, which is getting near the kind of bearish extreme that gets us into bullish territory in this 'contrary opinion' indicator. It seems funny when you first start working with this concept, since a lot of bearishness reflected in put activity starts suggesting future RALLY potential. When everyone who wanted to sell in a given period has done so, a relatively small amount of speculative buying can make for a sizable, tradable, rally.

The amount of selling today and the high put volume relative to calls suggests that we may be getting near another bottom, even if just a temporary one. Another shot down would even better suggest a set up for this. Over to you House of Representatives!

GOOD TRADING SUCCESS!

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