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Mechanics of Short Selling, Naked Short Selling and Synthetic Short Selling

InvestorEducation / Learn to Trade Apr 14, 2009 - 05:04 PM GMT

By: John_Olagues

InvestorEducation Best Financial Markets Analysis ArticleThere is much in the media these days about short selling, naked short selling and the "uptick rule."  Some claim that naked short sellers collude with "Rumor Mongers" to collapse stock like Bear Stearns, Lehman Brothers and so on. There is little in the media about the specific mechanics of short selling or the concept of synthetic short selling.


Review of short selling.

Short selling simply is a bet that the value of a security will go down. There are several ways to accomplish that bet.

If you wish to short sell the common stock of a company, you simply find an owner of the stock who is willing to lend those shares for short selling purposes. Your broker can generally find that lender. The prospective lender is probably a customer of the broker who has an account with the broker. You instruct your broker to borrow and sell the amount you wish to short sell. When the sale is made the short seller owes to the lender of the stock the specific amount that he borrowed and sold.

When the short sale is made, the proceeds are placed in your broker’s account and you have to deposit margin to make and maintain the short position. If you are a market maker or a large customer of the broker, your broker will give you some interest on the proceeds of the sale. If your bet is successful and the stock goes down, you make a profit.

For example assume that on March 7, 2008 you had inside information that Bear Stearns would be "collapsed" from 70 to 4 and decided to short sell 100,000 shares short at 70.

Perhaps you were an executive from Goldman or J.P. Morgan* and just wanted to short the 100,000 Bear Stearns at 70 as part of a basket of shorts including Bear Stearns, Lehman, Merrill, and Citigroup. Your purpose was perhaps to hedge your massive Goldman or J.P. Morgan equity compensation positions without violating the Securities Act of 1934 and without alerting the public by having to file a SEC Form 4 report.

The short sellers would have had to deposit margin to make the short sale, the maximum being 50% of the value of the stock sold (i.e 50% of $7 million= $3.5 million).

When the stock went down to 30 on Friday, March 14, you would be $4 million ahead. Your margin requirement would have gone to $1.5 million and $4 million would be moved from your broker’s account to your account. You could have pulled out $6 million (i.e. $4 million in profit and $2 million deposited as your initial margin requirement would have dropped from $3.5 million to $1.5 million).

When the stock went to 4, your margin would have gone perhaps to $400,000 and your broker would have transferred another $2.6 million in profits to your account. You could have removed the $2.6 million plus $1.1 million of the margin.

If you did not buy-in the shorted stock, you would not have any tax liability, even though you made and received $6.6 million in profits.

Naked Short Selling

Naked Short Selling is merely making the sale of stock without borrowing the shares and rather than owing the shares to a lender, you fail to deliver and owe the shares to the buyer or his broker.

If the stock goes down as above, the gains and tax consequences to the naked short seller is exactly the same as the regular way short seller, except that the naked short seller may receive more interest on the proceeds since he did not have to borrow the stock.

The extra supply of stock created by the naked short seller is the same amount created by the regular way short seller and has the same depressive effect on the market as regular way short sales (whatever that is).

Synthetic Shorts

Synthetic Short Sales consist of selling calls and/or buying puts. Some synthetic short sales consist of selling calls and simultaneously buying puts both with the same strike price and expiration date (referred as conversions in exchange lingo). These "conversions" have what is referred to as 100 negative deltas. The effect of a 100 negative delta "conversion" is almost the same as a naked short sale of 100 shares. There is no borrowing of stock and in effect the converter, who does the trade at theoretical values with a contra party, receives interest on the proceeds. The margin required to do synthetic short sales is much less than shorting the stock.

In the case of Bear Stearns, there was massive buying of puts right prior to the collapse. The exchanges accomodated the insiders by opening new strike prices in very short term puts that had strike prices far below the market. There was little margin required and massive leverage to the buyers of those puts

The same tax treatment would be available to synthetic short sellers by exercising puts or having calls assigned as would be available to the direct short sellers of stock.

The Uptick Rule

The uptick rule, if it is again installed, in my view will have little effect on the betting on downward movement of stocks as synthetic short sales are always available without an uptick. If the uptick rule is installed, the only effect that will be had is a movement of regular stock short sellers to the options exchanges and away from stock trading.

All of the current commotion about naked short sales and the lack of the uptick rule facilitating and causing the collapse of Bear Stearns and other financials is nothing more than a misdirection of concern away from the real culprits.  Naked short sellers allied with "Rumor Mongers" are the current bogeyman in fashion, who like Al Quaida, are never identified or charged by our "law enforcement officials."

Many of the current  traders who have been making the short sales, be they regular way, naked, or synthetic,  are trading based on inside information originating from the highest levels of the Federal Reserve Board and Banks and the Board Rooms of the largest banks and hedge funds. These insider-tipsters and tipees designed and arranged for the collapse of those financial companies and profited by betting on their collapse by short selling and then paying little or no tax on the profits.

In the 1980s, the SEC went after inside traders like Milken, Boesky, and Levine. Each had to cough up their booty and spent time in a Federal Prison. But now, they operate knowing that they won't be caught as they use more sophisticated means of disguising their crimes with the SEC ignoring their crimes or in some cases abetting them. The insiders instead of being indicted are invited to read speeches at the Institutional Investors Council.

Perhaps the insiders are just more honest that those in the 1980s. *The equity grants to J.P. Morgan's top 15 executives in February 2009 approached $100 million, which is now valued at 60% higher at noon April 14, 2009. Not bad for executives of a company who received welfare payments from the U.S. Tax Payers of $80 billion over the past year.

By John Olagues

http://www.optionsforemployees.com

John Olagues is the owner and principal consultant for Truth IN Options and a recognized authority on listed and employee stock options.

After graduating from Tulane University (where he captained the baseball team and set many of Tulane's pitching records), John applied his B.A. in mathematics and his competitive spirit to the real world of stock options.

In 1976, John became a member of the Pacific Stock Exchange in San Francisco trading and managing options positions in scores of different stocks. John joined with Blair Hull to create Options Research, the first service to provide theoretical options values to market-makers and to the general public. In 1980, he became a member of the CBOE, where he personally traded more options in more diverse situations than any other trader.

Copyright © 2009 John Olagues - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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