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  • Mechanics of short selling, naked short selling and synthetic short selling

    Mechanics of short selling, naked short selling and synthetic short selling

    by John Olagues - Truth in Options

    There is much in the media these days about short selling, naked short selling and the "uptick rule." Some claim that naked short sellers collude with "Rumor Mongers" to collapse stock like Bear Stearns, Lehman Brothers and so on. But there is little in the media about the specific mechanics of short selling or the concept of synthetic short selling. Here is a concise explanation.

    Review of short selling

    Short selling simply is a bet that the value of a security will go down. There are several ways to accomplish that bet.

    If you wish to short sell the common stock of a company, you simply find an owner of the stock who is willing to lend those shares for short selling purposes. Your broker can generally find that lender. The prospective lender is probably a customer of the broker who has an account with the broker. You instruct your broker to borrow and sell the amount you wish to short sell. When the sale is made the short seller owes to the lender of the stock the specific amount that he borrowed and sold.

    When the short sale is made, the proceeds are placed in your broker’s account and you have to deposit margin to make and maintain the short position. If you are a market maker or a large customer of the broker, your broker will give you some interest on the proceeds of the sale. If your bet is successful and the stock goes down, you make a profit.

    For example assume that on March 7, 2008 you had inside information that Bear Stearns would be "collapsed" from 70 to 4 and decided to short sell 100,000 shares short at 70.

    Perhaps you were an executive from Goldman or J.P. Morgan* and just wanted to short the 100,000 Bear Stearns at 70 as part of a basket of shorts including Bear Stearns, Lehman, Merrill, and Citigroup. Your purpose was perhaps to hedge your massive Goldman or J.P. Morgan equity compensation positions without violating the Securities Act of 1934 and without alerting the public by having to file a SEC Form 4 report.

    The short sellers would have had to deposit margin to make the short sale, the maximum being 50% of the value of the stock sold (i.e 50% of $7 million= $3.5 million).

    When the stock went down to 30 on Friday, March 14, you would be $4 million ahead. Your margin requirement would have gone to $1.5 million and $4 million would be moved from your broker’s account to your account. You could have pulled out $6 million (i.e. $4 million in profit and $2 million deposited as your initial margin requirement would have dropped from $3.5 million to $1.5 million).

    When the stock went to 4, your margin would have gone perhaps to $400,000 and your broker would have transferred another $2.6 million in profits to your account. You could have removed the $2.6 million plus $1.1 million of the margin.

    If you did not buy-in the shorted stock, you would not have any tax liability, even though you made and received $6.6 million in profits.

    Naked Short Selling

    Naked Short Selling is merely making the sale of stock without borrowing the shares and rather than owing the shares to a lender, you fail to deliver and owe the shares to the buyer or his broker.

    If the stock goes down as above, the gains and tax consequences to the naked short seller is exactly the same as the regular way short seller, except that the naked short seller may receive more interest on the proceeds since he did not have to borrow the stock.

    The extra supply of stock created by the naked short seller is the same amount created by the regular way short seller and has the same depressive effect on the market as regular way short sales (whatever that is).

    Synthetic Shorts

    Synthetic Short Sales consist of selling calls and/or buying puts. Some synthetic short sales consist of selling calls and simultaneously buying puts both with the same strike price and expiration date (referred as conversions in exchange lingo). These "conversions" have what is referred to as 100 negative deltas. The effect of a 100 negative delta "conversion" is almost the same as a naked short sale of 100 shares. There is no borrowing of stock and in effect the converter, who does the trade at theoretical values with a contra party, receives interest on the proceeds. The margin required to do synthetic short sales is much less than shorting the stock.

    In the case of Bear Stearns, there was massive buying of puts right prior to the collapse. The exchanges accommodated the insiders by opening new strike prices in very short term puts that had strike prices far below the market. There was little margin required and massive leverage to the buyers of those puts The same tax treatment would be available to synthetic short sellers by exercising puts or having calls assigned as would be available to the direct short sellers of stock.

    The Uptick Rule

    The uptick rule, if it is again installed, in my view will have little effect on the betting on downward movement of stocks as synthetic short sales are always available without an uptick. If the uptick rule is installed, the only effect that will be had is a movement of regular stock short sellers to the options exchanges and away from stock trading.

    All of the current commotion about naked short sales and the lack of the uptick rule facilitating and causing the collapse of Bear Stearns and other financials is nothing more than a misdirection of concern away from the real culprits. Naked short sellers allied with "Rumor Mongers" are the current bogeyman in fashion, who like Al Quaida are never identified or charged by our "law enforcement officials."

    Many of traders who have been making the short sales, be they the regular way, naked, or synthetic, are trading based on inside information originating from the highest levels of the Federal Reserve Board and Banks and the board ooms of the largest banks and hedge funds. These insider-tipsters and tipees designed and arranged for the collapse of those financial companies and profited by betting on their collapse by short selling and then paying little or no tax on the profits.

    In the 1980s, the SEC went after inside traders like Milken, Boesky, and Levine. Each had to cough up their booty -- at least some of it -- and spent time in a Federal Prison. But now they operate knowing that they won't be caught as they use more sophisticated means of disguising their crimes with the SEC ignoring their crimes or in some cases abetting them. The insiders instead of being indicted are invited to speak at the Institutions Investors Council.

    Perhaps insiders today are just less pretentious than those in the 1980s.

    * The equity grants to J.P. Morgan's top 15 executives in February 2009 approached $100 million, which is now valued at 60% higher at noon April 14, 2009. Not bad for executives of a company who received welfare payments from the U.S. Tax Payers of $80 billion over the past year.

    See also:
    J.P. Morgan's Excutives Bonuses more Abusive than Merrill's

    iTulip Select: The Investment Thesis for the Next Cycle™
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    Ed.

  • #2
    Re: Mechanics of short selling, naked short selling and synthetic short selling

    Why don't they have to pay taxes on their gains?

    Comment


    • #3
      Re: Mechanics of short selling, naked short selling and synthetic short selling

      Originally posted by FRED View Post
      snip
      Armed revolt. Coming soon to America.*

      The American public will only take so much of this outright criminal activity. I just wonder what will be the final catalyst to make an armed revolt happen?

      I asked some people I know, who are for the most part complacent and law-abiding, what it would take for them to finally take a stand against the government (ie to actually revolt in armed conflict against the federal governments' actions), and they said all it would take at this point, based off of everything that has happened so far, would be enough other people to join with them to make it happen.

      I believe it will only take a few more trillion dollar bailouts coupled with a doubling in unemployment to 20% to fully set the American people off and it will be fireworks indeed.



      *this is a prediction, not a plan
      Every interest bearing loan is mathematically impossible to pay back.

      Comment


      • #4
        Re: Mechanics of short selling, naked short selling and synthetic short selling

        Lost me there. To what outright criminal behavior are you referring?

        I can't see people taking a stand against the government without something concrete to fight against or a specific end goal in mind. What would people rally against? Whose vision of a replacement are they backing? I might be naive, but I don't anything pushing towards a revolt or anything like that.

        Comment


        • #5
          Re: Mechanics of short selling, naked short selling and synthetic short selling

          Originally posted by ricket View Post
          Armed revolt. Coming soon to America.*

          The American public will only take so much of this outright criminal activity. I just wonder what will be the final catalyst to make an armed revolt happen?

          I asked some people I know, who are for the most part complacent and law-abiding, what it would take for them to finally take a stand against the government (ie to actually revolt in armed conflict against the federal governments' actions), and they said all it would take at this point, based off of everything that has happened so far, would be enough other people to join with them to make it happen.

          I believe it will only take a few more trillion dollar bailouts coupled with a doubling in unemployment to 20% to fully set the American people off and it will be fireworks indeed.



          *this is a prediction, not a plan
          *2bad:mad::mad::mad::mad::mad::mad::mad:

          Comment


          • #6
            Re: Mechanics of short selling, naked short selling and synthetic short selling

            I'm not sure I understand how losing a democratic election would lead one to armed insurrection. What is it about democracy that you don't like? Your guy can't always win in a democracy.
            "The test of our progress is not whether we add more to the abundance of those who have much it is whether we provide enough for those who have little." - Franklin D. Roosevelt

            Comment


            • #7
              Re: Mechanics of short selling, naked short selling and synthetic short selling

              Originally posted by govtraksam View Post
              Why don't they have to pay taxes on their gains?

              Because they never covered their shorts. Example:

              Short 100 shares @ $50
              Cover 100 shares @ $10 Taxes due on profit of $4,000


              Short 100 shares @ $50
              stock goes to zero Never complete trade. No taxes due on profit of $5,000



              However I feel there is something wrong with this. Tax should be paid. Also it is not right to not borrow the stock if you want to short it.

              Comment


              • #8
                Re: Mechanics of short selling, naked short selling and synthetic short selling

                Originally posted by govtraksam View Post
                Why don't they have to pay taxes on their gains?
                John Olagues replies:
                The short seller does not have to pay a tax until he buys the stock back. He can remain short as long as he wants without a tax on the gain. He can even buy calls or sell puts to hedge the short position with out incurring a tax liability, unless the buying of the calls or selling puts constitute a substantially identical position to a purchase of stock.

                If the company becomes bankrupt, the short seller could possibly be required to report the gain.

                John Olagues
                Truth In Options
                www.optionsforemployees.com
                phone 504-305-4449
                Ed.

                Comment


                • #9
                  Re: Mechanics of short selling, naked short selling and synthetic short selling

                  Originally posted by ricket View Post
                  Armed revolt. Coming soon to America.*

                  The American public will only take so much of this outright criminal activity. I just wonder what will be the final catalyst to make an armed revolt happen?

                  I asked some people I know, who are for the most part complacent and law-abiding, what it would take for them to finally take a stand against the government (ie to actually revolt in armed conflict against the federal governments' actions), and they said all it would take at this point, based off of everything that has happened so far, would be enough other people to join with them to make it happen.

                  I believe it will only take a few more trillion dollar bailouts coupled with a doubling in unemployment to 20% to fully set the American people off and it will be fireworks indeed.

                  *this is a prediction, not a plan
                  There is lots of talk on these pages about 'revolt', if only enough people knew what was going on.

                  Is 'enough' the key word here - are numbers simply the catalyst? What will ignite the masses, and toward what end will they be led? If revolt is called for, why aren't we iTulipers inspiring it already, since we know so much? Are we all just pussies who fritter away all of our energy on the internet?

                  These are not meant as rhetorical questions. I really wonder - why aren't we doing something? What should we be doing, if anything?

                  I'm plenty disgusted with the situation, pissed off even, but I'm not feeling motivated to take up arms against anyone. And I have the arms to take up if I were so inclined.

                  Its hard to disagree with BrianLs comment
                  Originally posted by BrianL View Post


                  Lost me there. To what outright criminal behavior are you referring?

                  I can't see people taking a stand against the government without something concrete to fight against or a specific end goal in mind. What would people rally against? Whose vision of a replacement are they backing? I might be naive, but I don't anything pushing towards a revolt or anything like that.

                  Comment


                  • #10
                    Re: Mechanics of short selling, naked short selling and synthetic short selling

                    The American people are sheep, but once the herd gets moving in an ignorant mass, who knows what or who they will trample.

                    The America that was formed has been lost, when the Former CEO of Goldman Sachs is put in charge of the taxpayers money, gets the main competition to GS to go under (Lehman), funnels trillions to the banks at tax payers expense. When the democratically elected officials no longer listen to the people ($700 billion bailout was opposed by majority of people), when there are no outlets for the anger, angst, when bankers are getting rich, when there is no democracy any longer.....that's when things explode. Unfortunately, the vacuum that is created is usually filled by an eloquent dictator, Mussilini, Hitler.....or another talking head that is running a certain leveraged country to remain nameless :rolleyes:

                    God help us all, it's either inflation, renouncing our debt or revolution.....nothing good this way comes.

                    Comment


                    • #11
                      Re: Mechanics of short selling, naked short selling and synthetic short selling

                      We are not supposed to live in a democracy but in republic. But unfortunately we do right now... and it will lead to some kind of conflict. Previously posted @itulip:

                      http://www.youtube.com/watch?v=DioQo...ww.itulip.com/

                      Comment


                      • #12
                        Re: Mechanics of short selling, naked short selling and synthetic short selling

                        To me it's not the criminal behavior- we all know this isn't against the law.

                        The pisser is this is what's running our country.

                        That's a pisser.

                        Comment


                        • #13
                          Re: Mechanics of short selling, naked short selling and synthetic short selling

                          "The extra supply of stock created by the naked short seller is the same amount created by the regular way short seller and has the same depressive effect on the market as regular way short sales (whatever that is)."

                          This isn't my line of work and I admittedly am not a trader but this comment doesn't ring true to me.

                          First, there is no limit to the number of shares that a determined and well capitalized naked short seller can sell into the market to depress the price. The normal short seller is limited by the number of shares he can borrow. As the number of shares available to borrow dries up, the cost to borrow them goes up and would be self correcting, at least that is my understanding.
                          Therefore, a well capitalized naked short seller can absolutely destroy a small company (that depends on stock pricing to attain access to capital) even though the majority of shareholders don't sell. That doesn't seem fair at all to me.
                          In addition to that, how about the sharpshooters starting one of those offshore LLC's that default to the new owners of these false shares? How is that fair?
                          Also, how about voting rights?
                          How about naked short selling ETF's like SLV where there is supposed to be physical metal backing each share? I think the whole mess stinks and should be illegal. I'm surprised this guy is giving his stamp of approval to this activity by not pointing out these issues in the article. The difference between shorting borrowed shares and naked shorting is night and day, IMO.

                          Comment


                          • #14
                            Re: Mechanics of short selling, naked short selling and synthetic short selling

                            Originally posted by govtraksam View Post
                            Why don't they have to pay taxes on their gains?
                            to clarify further: the value of your house goes up. you take out an equity loan on the increase. you do not pay capital gains tax.

                            Comment


                            • #15
                              Re: Mechanics of short selling, naked short selling and synthetic short selling

                              Little Visual for the Sheeple.



                              Hedge Funds and the Global Economic Meltdown from Judd Bagley on Vimeo.
                              Last edited by seanm123; 04-14-09, 09:43 PM. Reason: pasted video

                              Comment

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