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Specialists Use Of The Short Sale
To understand the specialist’s practices, theinvestor must learn to think of specialists asmerchants who want to sell an inventory of stock at retail price levels. When they clear their shelves of their inventory of stocksthey will seek to use their profits to buymore inventory at the wholesale pricelevels. Once you grasp this concept you areready to learn the eight laws of thespecialist:
1)
As merchants, specialists will expect tosell at retail what they bought at wholesale.
2)
The longer specialists remain inbusiness, the more money they willaccumulate to buy stock at wholesale,which they then want to sell at retail
.
3)
The expansion of the communicationsmedia will bring more people into themarket, tending to increase volatility of stock prices as they increase elements of demand - supply
.
4)
In order to buy and sell huge quantities of stock, Exchange members will seek newways to enhance their sales techniquesthrough the use of the news media
.
5)
In order to employ ever increasingfinancial resources, specialists will have toeffect declines of ever increasingdimensions in order to shake out enoughstock
.
6)
Advances will have to be more dramaticon the upside to attract public interest inorder to distribute the ever-increasingaccumulated inventories
.
7)
The most active stocks will require longer periods of time for their distribution
.
8)
The economy will be subjected toincreasingly dramatic breakdowns causinginflation, unemployment, high interest rates,and shortages of raw materials
.
The term “
auction market
”, for example,has a great pull on the public’s imagination.Investors have been lead to believe thatdemand sends prices up and supply sendsthem down. In fact, it is exactly the reverse.Most investors bypass the fundamental factthat big block selling by insiders at the topof the market can, of necessity, only be inresponse to public demand, just as bigblock purchases at bottom prices byinsiders can take place only if the publicsells everything in the fear stock prices aregoing lower.By scraping traditional theory it becomespossible to discover the true order of things,to show how the aspirations of investorscan be linked to the aspirations of thespecialist as he proceeds to merchandisehis stock.An investor makes a short sale when hesells stock he does not own. He borrowsthe stock to make delivery and expects theprice of the stock will be lower when hebuys later to return the borrowed stock. Anunderstanding of the specialist’s use of theshort sale can yield tremendous insightsinto the principle processes of theExchange.In order to put the short sale in proper perspective, the investor must first realizethat, according to the NYSE:Specialists carrying out their functions of maintaining markets do well over half of allshort selling
. “
The figure is approximately75 percent or more at market highs
.”
Thespecialists initially form their inventorieswith short selling usually to meet a heavyinflux of buy orders.
The importance of the short sale is in termsof the advantages it affords the specialistrather than the investor. Since Exchangeinsiders are at the center of things,however, it can be demonstrated that thereis no watertight compartment that separatestoday from tomorrow, or tomorrow fromyesterday. We must not dissociate thespecialist critical judgments involving theshort term from the larger context of his“long term” objectives.The short term, intermediate term, and longterm are not three different realities, butthree aspects of the same reality. Thespecialist predetermines the long term. Thefluctuations he creates in his particular stock to achieve his goal determine whatthe short and intermediate movements willbe within his major blueprint. This type of control over price movement is madepossible by the magic of the short sale.For example, when the Dow averageadvances after a major bottom has beenestablished in the market and then movesback down to that bottom for a second (or third) time, the investor is always told that“the market is testing it’s bottom.” This is anabsurd idea for an operation in which theshort sale has been employed to halt theadvance caused by public demand for thestock at wholesale price levels.The public, in other words, has moved intothe market to soon and had acquired stocksthat, in the opinion of the Exchange“rightfully” belonged to insiders. As pricesrise, selling short to supply public demandhalts the advance. Then once demand fallsoff, prices are pulled back down towholesale price levels and investors aretold, “the market is testing its bottom.” In thecourse of this decline specialists are able todo two things:
1)
Shake out investors who fear the marketmay again go lower.
2)
Accumulate additional inventories of stock for a second set of investmentaccounts.Public selling at the bottom is what enablesthe specialist to employ his short coveringoperations. These transactions then serveto halt the decline. Thus we see thatanother major function of the short sale isthat it enables specialists to absorb publicselling in the course of a decline and to haltit at a predetermined price level.When public selling has exhausted thecovering potentials of the specialist’s shortsales, specialists purchase the additionalstock being sold by the public for their ownaccounts before taking prices up. Thus, theshort sale instrument allows the specialist tocontrol stock prices in much the same wayas you control an elevator, advances canbe halted and declines begun with shortselling, while declines can be halted andadvances begun with short covering.Unfortunately, the SEC does not provideinformation about the specialists’ shortsales until a month or more after his shortselling has taken place. Regarding thespecialists short covering transactions,nothing at all is published. Yet, they signalthe specialist system’s decision to reverse amarket downward in order to inaugurate abull raid on the market.In 1935 the SEC had requested stockexchanges to initiate controls over theshort-selling practices of the stockExchange insiders. It had come uponconclusive evidence that exchangemembers were conducting massive short-selling operations that serve to “demoralizethe market.In the early and middle 1930’s, over theviolent opposition of the heads of the StockExchange, evidence came to light that short
selling by the Stock Exchange members atprices lower than the last sale exerted ahighly depressing effect on the market. In1935 therefore, although short sales werepermitted at the last sale price, a rule wasinstalled that prohibited short-selling at aprice “below” the last sale price.At the time the SEC voiced the hope thatthe rule would “preserve those features of short-selling which are in the publicsinterest. “Since there is nothing about shortselling that is in the public’s interest”, theSEC was employing a euphemism whichsuggested that if the Exchange was goingto guillotine the public it shouldn’t do it inbroad daylight.In the fall of 1937 there was a sharp drop inthe market, and the Commission began a“study of the market decline” with a view toreassessing the Exchange’s short sellingrules. The hearings produced rules thatsupposedly corrected the limitations of the1935 rule.They also defined a short sale as
“
any saleof a security which the seller does not ownor any sale, which is consummated by thedelivery of a security borrowed by, or fromthe account of, the seller.
”
The importantpart of this new set of rules, however, wascontained in paragraph (A) of the secondrule, which stated: “No person shall effect ashort sale of any security at or below theprice at which the last sale was effected onthe Exchange.”This meant that all short sales wereprohibited unless they occurred at a priceabove the last sale price, usually at least aneighth of a point. The principle purpose of this rule, of course, was to prevent shortselling at successively lower prices therebyeliminating the use of this instrument by thestock exchange “
Bear Raider
” to drive themarket down. Such short selling waseffected on “
Minus Ticks
” when publicoffers to buy stock at a specific price levelwere exhausted by the short selling of insiders.Invariably, however, there were buy ordersentered on the specialist’s book at lower price levels. Specialist then dropped pricesand sold short to these orders. Obviouslythe short sale up tick rule was aimed ateliminating the use by specialists of theorders entered on their books.Another provision of the same rule statedthat all sales were to be marked either
“long”
or
“short”
. In the months after adoption of the Commission’s rules, thetotal short interest on the New York StockExchange declined more than 50 percent,and Exchange officials suggested, and hadextensive discussions with the Commissionabout modification of the rules.The new rule was apparently having a greateffect on profits. Under thesecircumstances, the NYSE makes the factknown to the SEC that its rule is serving tolimit the great exclusive privileges of Exchange members. Ultimately an SECcommissioner is found who is willing toimplement the Exchange’s suggestedcourse of action to remedy this problem.For this reason
Rule 10a-1(a)
was modifiedand the Exchange was provided with rule
10a-1(d)(1)
. There is no informationpublished anywhere, however, of anypermission having been granted by theSEC that tells the public that specialists cansell short without disclosing the fact thatthey are doing so, or sell short on “minusticks.” For the SEC to publish thisinformation would be to admit that it isallowing Stock Exchange insiders to exploitthe existence of the auction market in a waythat Congress had sought to prevent. Yetthat is the whole point of the rule.
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Specialist Use of the Short Sale by Richard Ney
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| Upload Date: | 11/28/2009 |
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