April 23, 2009
Naked short selling destabilizes the market. Highly advanced analytical tools can generate programs that can fairly reliably detect trends and small differences in derivatives that allow for a no risk transaction. These tools have been developed by highly skilled mathamaticians and are beyond the means and capabilities of the average investor. Since these differences tend to be small, large amounts of capital has to be inserted into the market to generate the profits that make such a trading strategy work. I believe that because these difference are small, and the investment size is large, such activities have nothing to do with the underlying value of the security. What results is a fairly accurate "public opinion" that generates information that can be used to profitably use the market to trade by predicting market movement. Such activity can also drive the market as can easily be seen by calculating what percentage of the daily change in the indices occur in the last 30-45 minutes of the trading day.
Short selling is an important aspect of the market in terms of determining by proper analysis what the true value of a company might be. The market is supposed to be about value trading one of the reasons the SEC is so concerned about insider trading. Naked short selling generates a kind of insider information that is not available to the average value investor.
The solution is simple. Put a one day hold on short sales. This will force investors to actually know something about the companies they trade.
Las Vegas has banned card counting as giving the card counters an unfair advantage. We should be doing the same in terms of insuring that the majority of the trades on the exchanges be related to value and not statistical trends that are unavailable to most investors.