Use Futures to Go Short

Let's distinguish between short-selling and naked short-selling. The former involves locating a stock, borrowing the shares and selling them; the latter skips the location of the stock and borrowing same. As option market makers in particular have emphasized in recent days, their ability to engage in naked short-selling until such time as shares can be located and borrowed is vital to their ability to function in today's electronic markets. Both market makers and normal short-sellers have a vital role to play in markets.

These short-sellers are exposed to a number of risks, including the risk of recall by the stock's beneficial owner. Moreover, the costs involved are non-transparent: The rebate of interest earned on the sale's proceeds is set bilaterally by the lender and the borrower and can vary from a near-full rebate on easy-to-borrow issues to a negative number for those stocks that are hard to borrow. It becomes like airline pricing, where no two passengers may be paying the same rate for the same service.

Now, if you go short the SSF, several of these problems are solved instantly. First, you can go long or short the SSF in a vacuum, just the way you can in any other futures contract. If you go short crude oil futures, you do not have to locate 1,000 barrels of crude oil and borrow it first. The long side of this trade is engaging in an opposite commitment, to take delivery of 100 shares at expiration. The net price impact of you selling and someone else buying should be zero.

Second, futures contracts have a de facto European exercise; while you can offset your short position by buying the short futures position back prior to expiration, no one can force you to make or take delivery of the underlying 100 shares of stock prior to expiration. As an aside, SSFs differ markedly from most other futures in the percentage going to delivery; nearly 95% of the contracts are settled by making or taking physical delivery of the shares.

Third, the costs involved in SSFs are known and once the trade is made are fixed. The fair value of a SSF is the stock plus the short-term interest rate cost of carry minus the future value of the expected dividend. That fair value is held in place by arbitrage; should the price of the future get driven down by short-sellers, it would be too easy for an arbitrageur to sell stock, either short or out of inventory, and replace it with the depressed SSFs. The opposite exchange of futures for physicals, or EFP trade, would occur if the price of the SSF got bid too high.

---

At the time of publication, Simons had no positions in the stocks mentioned.

Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.