Tuesday, September 23, 2008

Frontloaded Shorts

In the last post I discussed how a disciplined approach to shorts might reduce problems with failures to deliver and reduce the detrimental effects of short selling creating phantom shares which lead to an aritificial devaluing of a stock. Central to the process is the realization that, when a trader lends shares to a shorter, that trader is no longer an investor in stock. The trader has traded an investment in a company with a loan to a short seller.

In this post, I thought I would describe a different way to do a short sale. For wont of a better term, I decided to call this approach a frontloaded short.

In a frontloaded short, a trader owning shares of a company enters a deal with a short trader and sells his stock. Money from the sale drops into the account of the original stock owner. The two traders have a contract wherein the first trader will buyback the stock, and the two traders would settle the differential between the selling and repurchase price.

The main advantage of a frontloaded short is that the original investor is the holder of the money. This reduces the extent to which the person lending a stock becomes a creditor of the short seller. It also removes the temptation for people to short stocks as a capital raising mechanism.

BTW, it is possible in such a contract to add an escape clause for the short. The clause might say the shorter will skip the buy back and pay the difference in stock price to the original trader if the stock price hits a certain strike point. A short, after all, is not really an investment stock. A short is an off table deal made between two people gambling on the direction of the price with stocks as poker chips.

Now, if the short really is just a bet between two gamblers, one wonders if there is any value to involving real shares in the bet.

Reach Upward pointed me to a piece in the WSJ by L. Gordon Crovitz titled "Information Haves and Have Nots in which Mr. Crovitz claims that the vital role played by shorts is to provide information to the market. People who have information that a stock is overvalued short.

So, a primary reason that people want shorting is so that the sale provides information to the holders of shares of a stock that it is overvalued.

Unfortunately, this view is premised on a false assumptions that short sellers actually do have access to information not available to the rest of the investing world, and that short sellers are somehow altruistic fountains of virtue.

The reality is that people are very cunning. People are as apt to use the short process to create disinformation. Take over strategies almost always involve feints with shorts. Even worse, shorts often don't reflect information about the underlying security, but may be the result of a change in the internal trading strategy of a hedge fund.

If Mr. Covitz's assertion that shorts bring information to the market is correct. Then the massive short selling of 2008 should have resulted in a situation where prices are better known.

The reality appears to be the opposite. It appears that the massive short position has done little more than to give the financial market a wedgie. The market is more confused about prices than ever. People are having to give massive discounts to trade items magnify the liquidity crisis.

I am back to the opinion that the people who lend shares to shorters and the short sellers themselves are simply gamblers using stocks as poker chips. The information from this game is low quality and has effectively fogged the process of valuing properties.

As mentioned in the post Free Markets Don't Wear Shorts I contend that short selling (the selling of things that don't exist) is not something that would occur in a natural market. Short selling is an artificial device created by regulators that concentrate benefits on the few at the expense of the many.

Removing the regulations that allow shorting would be in order.

The proponents of short selling claim all sorts of altruistic motives for the shorts. Unfortunately, whether you frontload or backload the shorts, the shorts seem to do little more than divert large money from investments into a side show gaming market that ultimately undermines the market.

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