Been a trader with Bright for 9 years, never post, but here is my opinion on the recent market collapse. SHORT SELLERS TO THE RESCUE? October 8, 2008 âMarkets fall around the worldâ, seems to be a recurring theme in newspaper headlines these days. Everyone has their doom and gloom scenarios. Market commentators such as Jim Cramer are now encouraging investors to raise cash as we may fall to DOW 7500. Even a coordinated rate cut by all the central banks in the world today, could not keep this market in the green. So what is the problem? It is the fact that you canât short the financials. Yes, you are reading this correctly, the problem lies in the fact that we have handcuffed the shorts. Now donât get me wrong, the market has a lot of fundamental problems. However, the short selling ban has exaggerated the market fall over the past three weeks. It all has to do with understanding market mechanics in the trading world. The market price of a stock is a complete function of supply and demand. Short sellers add supply to the market by selling stocks that they donât own. So it is logical for the SEC and the general public to assume that if you take short selling out of the equation, you reduce supply, and if you reduce supply, and demand remains constant, the price of the underlying instrument should increase. This is true. The problem that the SEC and the general public havenât realized, is that short selling also increases demand. YES, thatâs right, short selling can actually increase demand. There are a number of fundamental reasons behind this. The obvious one is, when you sell a stock short, you will one day have to re-buy it. Therefore, when a person shorts a stock they become a potential buyer. You can analyze the short interest of a stock to see how many shares have been shorted. The larger the short interest, the larger the potential short squeeze. A short squeeze occurs when the stock starts to increase in price, and people holding short positions stumble over themselves trying to cover, thereby driving the price higher. Almost all market bottoms are formed not because of fundamental changes in the economy, not because of interest rate cuts, but because of short squeezes. The short squeeze starts the party, so to speak. This increase in price attracts other participants (who donât want to miss the bottom), so they start buying as well. Then more investors join the party, and before you know it, the stock has had a dramatic bounce from its low. Our problem right now is that we have no-one to start the party, no-one to put their finger on the buy button. Short interest in all of the financial stocks has decreased substantially, because once a short position is covered, the SEC has made it illegal to put the short back on. Until the short interest begins to rise in these stocks, there is going to be no violent rally to get investors excited. Another problem by taking short sellers out of the equation, is that you make the open book of the stocks thinner. The open book is the collection of buy and sell orders in any given security. It shows you who is willing to buy or sell the stock and at what price. Before the short sell ban, the open book was much thicker in financial stocks. There were short orders on the sell side of the book, and short covering buy orders on the buy side. However, on September 19th, the books got much thinner. Eliminated were all of the short selling orders, but more importantly so were the short covering buy orders (once they did their initially covering), thereby making the buy side much thinner. This would mean if selling pressure is kept constant, and the buy side is thinner, the price will fall more rapidly (as there are less buy orders to fill the sell orders). This is the fundamental reason for the rapid sell-off in the markets. There are simply not enough buy orders, to fill the sell orders. Volume has not increased substantially. There isnât a bombardment of sellers overpowering the buyers. There simply are not enough buyers to fill the orders. And this is because the open book has dried up. The lack of short covering orders is a big reason for this thin book. Some may argue that this argument doesnât hold water, because of the fall in the stocks that arenât on the short-ban list. The commodity stocks have been obliterated, and theyâre not on the list. How do you explain that? It comes down to the fundamentals of the market. The financials are the leaders right now. As they go, the market goes. Every time a financial firm collapses, itâs one less firm to loan money. Most companies (especially the oil stocks) borrow to finance their operations. If they canât borrow, they canât make money. So, as the financial sector falls further, the fear increases that there will be more bank failures and lending will get tighter. This is a real problem right now. There will be more bank failures with or without the shorts. But as the market continues to fall, as our financial leaders continue to fall, confidence continues to decline. And if the banks lose the confidence of their customers, their customers will begin to make withdrawals. If too many customers make too many withdrawals, the bank risks insolvency. So in essence, the fall in the market price of these stocks, can lead to bank failure as the customers become more fearful of their bank going down. We need someone to step up, someone to start the party, someone to bid the distressed bank stocks. We need a short seller. A short seller has no fear to bid a stock. He canât lose his investment by bidding the stock, as the buy ends his trade. In contrast, anyone else who bids the stock has his entire investment to lose. When a stock is in such distress, and nobody in the world wants to buy it, the short has nothing to lose by bidding his short stock. So he is the bidder. Those bids bring confidence to the market. The mentality of the trader is âif someone is willing to bid, then Iâm willing to bidâ. Itâs just like an auction. The auctioneer looks to the crowd to get that opening bid. Once he has it, he knows others bids will follow. Once you have a bid, traders will jockey for position, increasing their bids over each other, and in essence creating the squeeze. But if nobody is willing to bid the stock, then this process never gets started, and this leads to thinner open books, and lower market prices. Tomorrow the short sell ban will be lifted, and financial stocks will become fair game again. In all likelihood, we are going to have another fall, as shorts put their positions on. But as those short interests begin to rise in the financials, the potential for a short squeeze rises. Once we have a significant short squeeze, we can have a bottom. Hopefully, the SEC goes through with the lifting of the ban, and hopefully itâs not too late. Do I have an opening bid?