Extreme stock market volatility often pushes the average investor into making bad investment decisions. "Panic selling" is a common term used to describe stock market selloffs. Rarely, however, is the term "panic buying" used to portray strong, triple-digit stock market rallies, as indicated by the DJIA.
Panic goes both ways – in buys and sells – which explains why several days of bruising stock market losses are routinely followed by a couple of triple-digit market rallies. Short selling is at the core of this extreme volatility.
Successful investing is traditionally defined as Buying Low and then Selling High. Short selling works in reverse order: Sell High and then Buy Low. Short selling is the act of selling first, and then buying low at some later point in time.
In order to "sell short," an investor must borrow shares of stock they wish to immediately sell. An investment bank – such as Goldman Sachs, Merrill Lynch, and Morgan Stanley – "broker" the transaction between investors, both borrowers and lenders of stock.
For example, the short seller borrows stock X from an investment bank and immediately sells stock X for $50. Three days later the stock market sells off and the price of A stock drops to $30. The short seller then buys stock X and uses it to repay the investment bank – keeping the $20 difference as profit (less the fees owed to the investment bank, of course.)
Even today most people know of the vast Kennedy fortune. Joe Kennedy, father of John F. Kennedy, was famous for his stock market prowess. This is the reason President Roosevelt appointed him to be the Commissioner of the Securities and Exchange Commission (SEC). In 1938, as SEC Commissioner, Kennedy instituted what is known as the "Uptick Rule."
The Uptick Rule limited short selling to stocks that have moved up in price – even if by just a tick. In other words, an investor couldn’t short sell a stock that was dropping in price. Only owners of stock could sell during market meltdowns.
That’s the way it should be.
Joe Kennedy knew the abuse that unbridled short selling could inflict upon the stock market. He made a king’s ransom doing it. But the roaring ‘20’s were over, and now he was working for FDR. Kennedy’s aim with the Uptick Rule was to minimize stock market volatility. The Uptick Rule does just that.
The Uptick Rule reduces the number of speculators looking to exploit hostile conditions and/or fragile investors. By so doing, stock prices are under less downward pressure and volatility is reduced. For some irrational reason, the Uptick Rule was repealed in 2007 under the Bush administration.
This kind of crazy volatility that the stock market is currently experiencing is only good for Wall Street’s business and hedge fund traders. Wild swings in price create panic and increase transactions (to buy and sell). Panic can cause average or fragile investors to Sell Low during market meltdowns because they’re scared. It can also prompt these same investors into Buying High after the stock market "recovered" because they don’t want to miss a chance for big gains.
Short sellers are once again at the epicenter of volatility – this time upward volatility. Since short sellers lose money if stock prices go up, they place cat-like focus on "the market" and wait for it to stop falling. Once it does, they all start buying to cover their short positions (to thus repay the stock that they borrowed.) This forces stock prices to move higher – like we’ve seen the past two days.
Each time this happens, when investors panic and Buy High and Sell Low, they lose a piece of their wealth and Wall Street gets richer. Extreme volatility facilitates this.
Fix "the market": Reinstate the Uptick Rule!
Until then, Volatility -- Get used to it!