We had this in an email from a trading friend George Slezak regarding unintended consequences of the ban on shortselling that the SEC enacted unexpectedly on the markets last Thursday evening.
Our reaction was more optimistic because we suspected that the markets would adjust fairly quickly since it is temporary, affects only 800 stocks, and can be arbed out in the case of the broader indexes most affected. We respect George's experience and have a watchful eye out however.
It would be ironic indeed if the crony capitalists managed to crash the economy and kill off free markets as we have known them, after capitalism won the Cold War. But as we have pointed out here in the past, their defense and attachment to economic freedom is only a thinly masked rationale for privilege, patronage, and pilfering.
As a trader on the trading floors of both the CBOE trading stock options and the CME trading S&P futures for more than 15 years, I want to explain that the short sale ban will have a dramatic impact on the liquidity of the stock market futures and options. When there are more sellers than buyers in the option and futures pits, the prices of the futures and options drop to a level where index arbitrage provides liquidity by shorting a basket of stocks and then buying the futures or option.
In a competitive market, the arbitrage of the futures versus the underlying basket of stocks is done for fractions of a point versus fair value. Losing the ability to short stocks to transfer the selling in the futures and options to the underlying equity market will, in my opinion, result in the futures and options trading at severe discounts to the fair value.
This overhang will drive buyers away from the markets. For example, imagine the S&P futures trading 36 points (3%) under fair value. Will you step up and buy stocks when you see the futures forecasting that the entire index is being sold in the futures market 3% lower than the current market?
Liquidity for ETFs is provided in a similar manner to the Index futures and options. Normally when ETFs trade at a small discount to fair value, arbs would short stocks and buy the ETFs locking in generally a fractional spread. Now, the short side arbitrage cannot be done and if we see index ETFs trade at substantial discounts to fair value, I think those EFTs, by their own rules, begin liquidation of the underlying basket of stocks they hold.
On Friday evening the December S&P futures settled 9 points lower than the S&P 500 index. Fair value is several points higher than the index close. If this discount to fair value persists DURING in the trading day on Monday, I expect we will see the market to start to go into a spiral decline....
