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As prices sway, volatility spikes |

As prices sway, volatility spikes

| Sunday, August 5, 2007 12:00 a.m

Stock market volatility has increased significantly. This is most obvious in the increasing numbers of trading sessions in which the major averages and individual stocks have had abnormally wide price swings. Although there were several causes for the increased volatility, a recent Securities and Exchange Commission rule change may have made what was abnormal into a new standard of trading.

Effective July 6, the SEC revoked the short selling “uptick” rule that directly impacted only a small segment of the investing public. The change only directly touched a small minority of investors, but it indirectly had an outsized effect on the overall market and almost all investors.

Short selling is the technique of selling a security you do not own in hopes that you can buy it back at a lower price and pocket the difference. Short selling always has been subject to stringent regulation — always, that is, after the mid-1930s when regulators realized the abundance of short selling abuses that existed before the 1929 market crash.

Prior to the implementation of the SEC rule change, short sellers had to satisfy two basic requirements.

Buyers of any security do not care whether they buy it from someone selling the stock who owns it, commonly called a natural seller, or from someone short selling the stock. They want the stock delivered to them.

The first major short selling requirement is that you need to have access to stock to deliver to the buyer. Except in thinly traded stocks or in issues involved in a special situation like a takeover, satisfying this requirement usually is easy. A short seller’s broker either provides the seller shares from his own inventory of loan-able stock or they go to another firm that can provide the shares.

The second and often more difficult requirement used to be that a short seller could only execute the trade on an uptick or a zero plus tick, meaning that the sales only could take place when the stock was up from its last trade or was flat with a prior trade that itself was an uptick. The rule was sufficiently difficult to satisfy that it was not uncommon for pending short sales in stocks under significant selling pressure to go unexecuted because the tick requirement could not be met.

Prior to the rule, short sellers merely could keep selling a stock and, on their own, drive its price lower. It was an artificial way for large pools of money potentially to control the market in a stock. The requirement to borrow shares before entering a short sale prevented what now is termed naked shorts where short sellers sell an issue but never make delivery. It is rare, but when this rule illegally was ignored, there have been occasions when a short position (the number of shares sold short) exceeded the total number of shares outstanding in a company.

The efficacy of both short selling requirements makes the SEC’s decision to rescind the uptick rule particularly bewildering.

The SEC conducted a lengthy investigation of the possible result of removing the tick requirement and concluded that the long-term benefits outweighed the negatives. Time will tell on this score.

The more immediate impact already has had a much farther reaching effect than the SEC had in mind.

Prior to the rule change, if you had asked any desk trader at a brokerage firm what the potential outcome of the rule change could be, the answer uniformly was that it would increase volatility. And so it has.

About two weeks after the effective date for the rule change, the Dow Jones Industrial Average produced several sessions in which intraday volatility moved the average 300 and 400 points. The net results on two of the days were losses of more than 200 and 300 points.

The market drop was not caused by the rule change, but there is little doubt that it made the slide occur faster than it might have otherwise.

The change ensured that increased volatility is here to stay as long as the new regulation remains.

Volatility is the spawning ground for profit potential, assuming, of course, that you gauge it correctly.

You have to wonder, however, if the typical long-term investor welcomes the greater volatility, particularly when the recent rule change enhances the chance that a downwardly biased market might get a more rapid shove lower thanks to the absence of the uptick rule.

Categories: News
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