Frozen In My Shorts

In my personal account — not for The Kelly Letter — I’ve been trading this week. I think trading is a bad idea for 99% of people, which is why I don’t suggest it to my readers or subscribers.

Still, I’ve been in this business a while and engage in short-term trading personally from time to time. This week was one of those times.

This morning, I bought ProShares UltraShort Financials (SKF) at less than $88. It shot to $93 almost immediately. I set a safety stop market order to sell the entire stake at $92. The bid and ask prices are flickering in the $94 to $96 range, but the listed market price is parked at $93.

I’ve never seen that before. I’m guessing the ban on short selling just kicked in.

[Update at 10:30 a.m.]
I spoke with ProShares and they said SKF is frozen while they look into how the ban affects the ETF. The SEC banned shorting of 799 financial companies. However, SKF doesn’t short the stocks. It buys swaps instead. Nobody knows how swaps are affected by the ban.
[End 10:30 Update.]

[Update at 11:50 a.m.]
SKF began trading again, so I guess swaps that make money as financial stocks go down are OK, but shorting financial stocks to make money when they go down is forbidden. I sold at a little under $95, making a good trade, but suffered a nail biting hour when the bid got stuck at $0. Quite a week.
[End 11:50 Update.]

Meanwhile, ProShares Ultra Financials (UYG) is falling from its opening high. Bennet Sedacca at Minyanville wrote at 9:40 this morning:

The federal government just declared war on short sellers.

Will it help the real economy? No sir.

Will it help the value of my house? Nope.

Will it blow up hedge funds? Yep.

Is it a selling opportunity? You betcha.

Will the rally last? No.

Will earnings increase? Actually, I think they will fall.

My conclusion? The pain trade, after this burst, is a crash in October.

Yes, a crash.

I am not talking my book, as my firm is delta neutral.

What makes me ill is that folks in the media are the mouth piece of the irresponsible government officials.

I am sick to my stomach watching socialism take over.

So am I. Ten minutes later, the Minyanville staff wrote:

Short sellers borrow shares of stock and sell them in the market, hoping to buy them back at a later date at a lower price. The SEC, and firms such as Morgan Stanley (MS), JP Morgan (JPM) and Goldman Sachs (GS), among others, have been concerned with the practice of naked short selling. A naked short sell is an abuse of rules (rarely enforced) that prohibit traders from selling a stock without first physically locating and borrowing the stock and never intending to deliver it to the buyer at a later date.

Most people think of short sellers as bearish hedge fund operators holed up in dank offices betting against the fate of a hapless corporation somewhere. But the reality is that the majority of short selling in markets is executed as some type of hedging transaction. For example, a firm that specializes in, or makes markets in, options, may sell shares of stock short to remain “delta neutral.” In English, this means the options trader is not exposed to the stock’s price movement.

Why would someone do this? The biggest reason is liquidity. The first casualty of the short selling ban will be liquidity.

The second casualty will be the synthetic demand that short sellers represent. Every share sold short must eventually be bought back at a later date. This layer of demand serves the critical purpose of softening declines. It is, at its very core, what makes a market a market; buyer and seller meeting to transact differing opinions about what constitutes value.

With short sellers absent, shares will initially rise. But once demand is satisfied, there will be no softening any declines. This could potentially create a vacuum below market prices and exacerbate a decline.

Surely the SEC knows this, so why are they doing it? The gambit by the SEC is two-fold. First, they hope to extend the ability of financial firms to survive this crisis by removing the pressure short sellers may cause to share prices. Second, they understand that the Treasury Department and the Federal Reserve most likely have a series of follow-on maneuvers planned that they hope will address the fundamental issues driving the debt crisis, which is the quality of the balance sheets of many banks and financial institutions.

The important thing to keep in mind is this is not a solution to the crisis, but a gambit. The risks are two-sided. It may succeed, but at a severe cost to the American taxpayer and to capital markets as we know them. If it fails… well, the consequences of that are rooted in the very origins of these policies: the Great Depression.

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