From: cbbrowne@csi.uottawa.ca (Christopher Browne)
Subject: Re: Should we limit the shorts life time?
Organization: Dept. of Computer Science, University of Ottawa
Date: Sun, 26 Jul 92 02:45:08 GMT

In article <sehari.712086539@vincent1.iastate.edu> sehari@iastate.edu (Babak Sehari) writes:
>In <1992Jul25.004059.21906@Princeton.EDU> jmo@courant.princeton.edu (Mike Orszag) writes:
>>In article <sehari.712013741@vincent1.iastate.edu>, sehari@iastate.edu (Babak Sehari) writes:
>>|> ---
>>|> 
>>|>   One of the reasons that stock market crashes is the frenzy of shorting
>>|> by big investors.  For example, Mr. Ross Perot have shorted $1M of citibank.
>
>>What effect would you estimate shorting $1 million dollars worth
>>of Citibank stock would have on the market? Shorting American bank
>
>By increasing the supply of the shares in the market, you bring the
>prices down, as it is predicted by the law of supply and demand.

O.K. - Let's be more specific.  What SPECIFIC effect would result from
$1 million dollars worth of Citibank being shorted by Mr. Perot?  Yes,
it sends a signal to the market that would encourage a price drop.
How strong will that signal be?  Is it likely to be significant?

If it is a significant signal, then maybe you have a point.  If the
signal is not significant, compared to the many random things
happening to Citibank prices, then WHO CARES?  If a tree falls in the
forest, and nobody is there to hear it, WHO CARES?

>That is,
>If total number of shares of say company A is 10 and one person shorts
>2 stocks of A, the total supply is 12 now.  That is an investor, who invested
>in this company and bought 2 stock and is not willing to sell at current price
>would deposit his stock with his broker.  Now, the person who shorts the 
>stocks with the help of the broker would sell the investor's stock and drive
>the prices down.  The person who really hurts in this deal is the long term
>investor, people like an old lady who buys and holds to stocks.  Besides,
>today we have other instruments that does not effect the price of the stock
>directly, such as options.

Unfortunately, this is not a correct assessment of the supply
situation.  Those 2 shares must in fact be owned by somebody else with
an account at the same brokerage.  The supply of "virtual shares" does
NOT go up. 

And please consider: Any time that someone SELLS shares on the stock
market, there must be a corresponding BUYER.  Those shares don't just
appear and disappear - there's always somebody who owns them.  Options
and commodity futures, of course, are a slightly different
situation...

>Options, which acts as an insurance for some investors; could be bought
>and sold by people, who are interested in this type of transaction.  Say
>you invested on ATT and bought 100 shares at $40, you could sell a leap
>of this stock at $45 for $5, and protect yourself from down side price
>fluctuation up  to %12.5.  This transaction does not increases the total
>number of stocks, so it does not influence the price of the stocks. So one
>by selling calls does not drive the prices down, the same is true by
>buying puts.  However, you can drive the prices down by aggressively
>shorting stocks.  The funny thing about it is that you do not have to cover
>your shorts by a certain time, you could cover it any time you wish.  Your
>broker does not asks you to cover your shorts unless the stocks go up
>in price.  So market should drive a 12 stock supply up instead of 10 stock
>supply.  Given the fact that you could short stock on exact time that
>the stock is at a critical stage to prevent it from taking off.  This is
>what I call "Market Terrorism".

In the same way, it is "Market Terrorism" when corporations float new
bond issues in order to pay off old bond issues that are coming due.
GM probably has a goodly number of billions of dollars of loans, and I
doubt that they will EVER actually pay them off.  They'll pay interest
to the investors, and create new 20 year bonds as old ones expire.
This drives up the money supply "artificially," and there's no rule
that says that you HAVE to make bonds that expire after 20 years.
Someone could, in theory, create bonds that expire after 25.  The
British government at one point issued "perpetuities" - bonds that
paid 6% interest (I think it was 6...) FOREVER.

What would be the "correct" date at which the short position would
have to be CLOSED OUT?  You do NOT mean "covered."  Perot's short
position in Citibank stock is eminently covered (I'm sure) by his
other assets and investments.  If the brokerage demanded the $1
million (or more likely the shortfall, which is likely to be less
than $1 million), Perot can pay it.  QED, the position is "covered."

What you're talking about is quite different; namely requiring that
Perot CLOSE OUT the short position after <X period of time,> paying
back whatever money may have been lost on the position.

>The shorting, therefore, hurts the people whom the stock market was
>created for in the first place, the real investors who invest in the
>businesses and companies.

It might have been possible for individuals to do "price fixing" at
some point in the past; it's much more difficult today, because the
markets have expanded greatly.  It used to be that one player might be
able to control a significant portion of the stock market; there's
more and bigger institutional players today.  Between the effects of
international investment and pension funds, they control a LOT more
stock than any individual "fixer" could short.  And pension funds
don't get to play speculative games that would allow them to do a lot
of shorting...

And remember that there IS a cost to holding onto a short position; if
Perot owes the brokerage a few hundred thousand dollars, they'll be
charging interest on the account.  This gives him incentive to close
out the short, unless he's really sure that the price will be falling
soon...
-- 
Christopher Browne
cbbrowne@csi.uottawa.ca
University of Ottawa
Master of System Science Program