Short sales –alternative methods: naked shorts, puts, convertible bonds and CFD's

There are several ways to “short” a stock, in addition to the usual technique so much explained during the recent short selling crisis in the UK and the US. A trader can make money on the decline in the price of the stock using several other strategies, and some of these techniques carry less risk than borrowing the security. So data on stock lending – shares out on loan, rates of borrowing, etc – doesn’t tell the whole story to the interested regulator, or guarantor of rights issues, or CFO, not by a long shot.

Short sales: stock borrowing and NOT Naked Shorts. How a short sale works has been admirably explained in the media during the past month. A trader borrows shares he thinks will decline in value, sells them immediately, waits for the decline, buys the same shares at a lower price and returns them to his lender. His Profit: the difference between the price he got for selling the shares high and buying them back low, less costs (of borrowing shares, etc.). His Risk: he could be wrong. The shares may go up. So he’s liable to the lender from now until the end of the world, or at least when he gives up the bet, buys back the rising shares, makes the lender whole, and takes a bath.

Naked short selling, temporarily banned in the US for the shares of 19 financial firms (the ban was lifted on 13 August, 2008), occurs when the trader sells shares short without borrowing any covering shares. The trader of a naked short executes a sale on the exchange, but doesn’t borrow the covering shares to deliver to the counterparty. Then, if the price of the shares drops, he buys them at that point, and delivers on his original contract to sell. If the price of the shorted shares doesn’t drop, he stiffs his counterparty: no delivery. This can be a cost-free exercise, until somebody catches you at it, as they might, for example, if the stock increases in value. Risk: dire. A “trail” of fail-to-delivers is left for all to see. A record of this sort of thing can be damming among counterparties; it can also flag down the odd regulator.

An obscuring difficulty here is that when a trader is dealing in an issue with many, many shares outstanding, and wants to move fast, the custom is to assume that he will be able to borrow the shares at an appropriate point (ten seconds after clicking on the trade, e.g.) and not have to “pre-borrow” the shares. Any regulator who wishes to eliminate the abusive practice of naked short selling must contend with this inconvenient practice that traders argue is necessary for speedy transactions. There is also the matter of how a regulator might police such a requirement; the FSA and the SEC experimental period in June and July of 2008 should produce some interesting anecdotal evidence.

Convertible bonds. First, you have to be trading in a company that has issued convertible bonds, as opposed to the company’s ordinary corporate debt. In this case, a trader can sell stocks short against the convertible bond, but he still has to arrange for the borrow of those shares, because he can’t deliver the convertible bond in lieu of the stocks he’s shorted. The advantage of this technique is that he won’t ever be caught without the position covered (in case the price of the share rises) because he can just convert the convertible bonds into the stocks he’s shorted, and close the trade.

Options. The trader can buy a put option rather than selling short. A put gives the holder the right to sell the underlying stock at a fixed price prior to the expiration of the put. One put represents 100 shares of stock of the underlying security. The holder of a put is betting that the underlying stock price goes down. No share borrowing is required. Risk: loss of investment only.

Contracts for Differences. Betting that shares will drop in price, a trader can take a short position in a CFD between himself and another party (usually a broker/dealer) to exchange, at the close of the contract, the difference between the opening and closing price of the shares. The trader doesn’t have to buy or borrow any shares to cover himself. Because they are off-exchange deals, contracts for differences have come up for a great deal of regulatory interest in the past several years. The risk of a contract for differences is that the price may go against the trader, in which case his investment is forfeited.

These are only the more common methods of making money in a tanking stock market on tanking stocks. It is easy, and unfortunately not very useful, to see any of them as the cause of a decline in the price of a share. It produces great press coverage, and contributes to the impression that the regulator is Doing Something about very complex problems. But since the cause of a declining share price is None of the Above, curtailing any of these practices will not prevent shares from declining. The shares of badly run companies will always attract short sellers. The role of rumors and inside information – that’s another story for another time.