The Other Side of Short Selling

In Europe… France, Italy and Spain have extended bans on short selling. While Belgium set ‘an indefinite ban’ on short selling two weeks ago.

The countries are worried that ‘bearish’ short-seller sentiment will drag their stock markets down.

They’re already at a two-year low…

The German DAX Index 13 September 2009-11
The German DAX Index 13 September 2009-11
Click here to enlarge
Source: Yahoo Finance

The five euro stock indexes we looked at this morning were up yesterday. But the ban on short selling hasn’t stopped volatility.

The DAX traded in a 5% range yesterday. The FTSEMIB (Italy) did the same. So did the CAC 40 (France)… The IBEX 35 (Spain) was slightly less volatile… It traded in a 4% range… And the BEL 20 (Belgium) moved in a 6% range…

Those are big price swings.

But banning short selling won’t stop the stock market falling. And it won’t stop volatility. In fact, it could make things worse.

Because what short sellers do, under normal conditions, is borrow stocks they think will fall and then – when they have fallen enough to take profit or risen too high to take the risk – buy them back.

That buying – called ‘covering’ – helps cushion the blow of a massive stock market plunge.

But no short sellers… No cushion.

Forcing traders to ‘only make money from stocks that go up’ is like forcing someone to climb a ladder and yanking it out from under them when they reach the top rung.

But for now, there aren’t any restrictions for short sellers in America. And it shows…

From Zero Hedge.

‘In the second half of August evil “speculators” did not relent in their negative bias, and brought the total NYSE Group short interest to a two year high or 14.9 billion shares, a 484 million share increase from the prior week, and the highest since July 2009…’

That means there are 14.9 billion individual shares that need to be covered. Do you see how this works? Sure, the short-sellers may have pushed the market down. But even a tiny whiff of good news from the next Federal Open Market Committee meeting could see the market rally from a ‘short squeeze’.

This is where short-sellers buy stocks to close their positions (sometimes they’re forced to as the market rises quickly). This creates buying pressure and can cushion the market from further falls.

The two-day meeting of the FOMC is only a week away. And because no-one knows for sure what the Fed will do, there’s a chance short sellers will cover their trades… and that means stocks could rally over the next week.

Short Interest (bar graph) vs SPY Close (red line)…
Short Interest (bar graph) vs SPY Close (red line)


Aaron Tyrrell
Editor, Money Morning

P.S. Slipstream Trader Murray Dawes feels the ASX may be on the verge of a squeeze. In his new free video market update, Murray will take you through what’s happened in our market recently and where he thinks it will head. To view the video, simply click here to visit Slipstream Trader YouTube channel.


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