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Time to Rethink Program Trades and Short Selling

Time to Rethink Program Trades and Short Selling

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Published by Harry Emerson
The purpose of this article is to raise issues and stimulate discussion on fundamental matters of the ways that the financial markets function and how that affects the economy and well-being of the nation. ECONOMIC DISASTERS ARE NOT UNAVOIDABLE -- they happen because our rules and regulations permit them to happen. We lost 2 trillion dollars of value in the last week of September and first 10 days of October 2008. If that's ok with you, then you needn't think about change. Otherwise, read on.
The purpose of this article is to raise issues and stimulate discussion on fundamental matters of the ways that the financial markets function and how that affects the economy and well-being of the nation. ECONOMIC DISASTERS ARE NOT UNAVOIDABLE -- they happen because our rules and regulations permit them to happen. We lost 2 trillion dollars of value in the last week of September and first 10 days of October 2008. If that's ok with you, then you needn't think about change. Otherwise, read on.

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Published by: Harry Emerson on Oct 23, 2008
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06/16/2009

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TIME TORETHINK THEFINANCIALMARKETPLACE
Talking Points
on Program Trades,Short Selling,Buying on Margin,Short-Term Holding,Speculation,Market Churn,and Tax Policy 
 
Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.com
TIME TO RETHINK THE FINANCIALMARKETPLACE
Talking Points
on Program Trades, Short Selling, Buying on Margin,Short-Term Holding, Speculation, Market Churn, and Tax Policy
We lost 2 trillion dollars of value in the lastweek of September and first 10 days of October2008. If that's ok with you, then you needn'tthink about change. Otherwise, read on.
Accounting scandals. Lying and cheating CEO’s. The Internet boom and bust. The WorldTrade Center September 11 catastrophe. The oil crisis. And now, “toxic mortgages” andthe financial industry melt-down. There’s much for the fingers of blame to point at toexplain the current disaster in the financial markets. But there’s much that isn’t beingdiscussed, especially in the context of recurrent financial industry disasters that affectevery American.The purpose of this article is to raise issues and stimulate discussion on fundamentalmatters of the ways that the financial markets function and how that affects the economyand well-being of the nation.
 ECONOMIC DISASTERS ARE NOT UNAVOIDABLE 
--they happen because our rules and regulations permit them to happen.
There are four elements of particular interest to this discussion: stock market controlsintended to minimize volatility; short selling; buying on margin; and government policies, including tax policy, to discourage short term speculation.
IMPORTANT BACKGROUND
In entering this discussion, the first and most important thing to realize about buyingstock is that the company whose stock you are buying doesn’t get the money. You arehorse-trading with someone else who already owns the stock. Therefore, proposals thatmight minimize volatility neither help nor hurt the company – they will, however, helpstabilize the market, which will help you, your retirement fund, and the nation as a whole.
A BRIEF HISTORY OF RECENT FINANCIAL DISASTERS
Remember Black Monday? The largest single stock-market drop in Wall Street historyoccurred on "Black Monday" – October 19, 1987 –DJIA plunged 508 points, from 2246to 1738, losing 22.6% of its total value. During the period of October 10th throughOctober 19th, the Dow fell by almost one third, representing a loss in value of alloutstanding United States stocks of approximately one trillion dollars. That one-day fallfar surpassed the one-day loss of 12.9% that began the great stock market crash of 1929and foreshadowed the Great Depression. The Dow's 1987 fall also triggered panic sellingand similar drops in stock markets worldwide.July 23, 2002 updated Oct. 2008Harry E. Emerson, IIIPage 2of 7
 
Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.comAlthough many factors were cited as probable cause for this crash, the major focus pointed blame on the use of computer trading (program trading) by large institutionalinvesting companies. In program trading, computers are programmed to automaticallyorder large stock trades when certain market trends prevail.In response, the New York Stock Exchange (NYSE) restricted some forms of programtrading. The NYSE and the Chicago Mercantile Exchange also instituted a "circuit breaker" mechanism by which trading would be halted on both exchanges for one hour if the Dow Jones average fell more than 250 points in a day, and for two hours if it fellmore than 400 points. The concept is to provide a cool-off period, and then to resumetrading at a more regulated pace by instituting curbs against program trading. The NYSEcontrols took effect on October 27, 1997 by halting trading for a total of 55 minutes whilethe stock exchange suffered the third biggest loss in the preceding 111 years.Since then the exchanges have been very forgiving to themselves, and have liberalizedthese circuit breaker rules to the point where they are only likely to come into play in thecase of an unprecedented financial disaster. Put in context,In the 2002 crises, the Dow Jones Industrial Average (DJIA) plummeted about 27% frommid-May, until October 1
st
, wiping out 5 trillion dollars of shareholder value. This was 14years after the controls had been put in place – 
obviously the controls are inadequate
from the standpoint of national well being.
PROGRAM TRADING "CIRCUIT BREAKERS" – RULE 80B
Circuit Breakers go into effect based on Dow Jones Industrial Average points. The pointvalues are set quarterly. The point values listed below are those in effect as of July 1,2002.If the Dow Jones Industrial Average falls 10% (1200 points), trading is halted on the NewYork Stock Exchange for one hour if the decline occurs before 2 p.m.; for 30 minutes if  before 2:30 p.m.; and have no effect between 2:30 p.m. and 4 p.m.If the Dow Jones Industrial Average falls 20% (2400 points), trading is halted on the NewYork Stock Exchange for two hours if the decline occurs before 1 p.m.; for one hour if  before 2 p.m.; and for the remainder of the day if between 2 p.m. and 4 p.m.If the Dow Jones Industrial Average falls 30% (3600 points), trading is halted on the NewYork Stock Exchange for the day.To put the circuit breaker rules into perspective, the companies traded on the NYSEcurrently have a total market value of about $16 trillion. If the DJIA dropped 20% wipingout $3.2 trillion of shareholder value, and if it happened between 1 p.m. and 2 p.m., the brokers would take an hour coffee break before opening the throttles again. That’s notmuch time for regaining composure – they need enough time to get a martini or two. Butyou need to understand their motivation – 
the objective of stock brokers is not topreserve the wealth of America, it is to buy and sell stocks, period. The more churn
July 23, 2002 updated Oct. 2008Harry E. Emerson, IIIPage 3of 7

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