Hedge Funds May Help Lower Volatility as Short-Selling Ban Ends

By Eric Martin and Whitney Kisling

Oct. 9 (Bloomberg) -- The end of a three-week ban on short selling financial stocks may reduce the market's record price swings as hedge funds increase trading.

Since the Securities and Exchange Commission started the rule Sept. 19, volume on the New York Stock Exchange dropped 35 percent and the Chicago Board Options Exchange Volatility Index surged to 57.53, its third straight record. Options on the VIX, as the volatility gauge is known, imply it will fall 44 percent in the next two weeks after the rule expired last night.

``Lifting the short ban restores the balance in the marketplace,'' said Peter Sorrentino, a money manager at Huntington Asset Advisors in Cincinnati, which oversees $16.5 billion. ``It should bring liquidity back into the market, which will cap some of the volatility we've seen lately.''

The SEC barred short sales of almost 1,000 finance-related stocks in a bid to curb speculation after the chief executive officers of Lehman Brothers Holdings Inc. and Morgan Stanley accused hedge funds of driving down prices. Companies on the SEC's list slid 18 percent on average during the ban, compared with 24 percent drop for all financial companies in the Standard & Poor's 500 Index.

Bank and brokerage shares led the S&P 500's 33 percent tumble this year, losing 47 percent as a group after almost $600 billion in losses tied to subprime mortgages spurred concern the U.S. economy is headed for a recession. The S&P 500 decreased 1.1 percent to 984.94 yesterday, its sixth consecutive retreat.

In a short sale, a trader tries to profit from a decline by selling borrowed shares in the hope of repaying the loan with cheaper stock.

Lower Volume

NYSE Euronext Chief Executive Officer Duncan Niederauer said Oct. 1 that the ban slowed stock trading and contributed to wider swings in prices. Average daily volume of shares on the New York Stock Exchange was 2.31 billion in the week the ban was adopted, compared with 1.5 billion in the 13 trading days since.

The restriction made stock trading more uneven because it ``substantially'' widened the gap between prices sought by buyers and sellers, Credit Suisse Group AG equity strategist Ana Avramovic wrote in a Sept. 30 report. The bid-ask spread on Goldman Sachs Group Inc. increased to $1.20 on Sept. 22, the highest since March 2007, according to data compiled by Bloomberg.

``Typically, with more participants vying for a trade, they will keep bettering the quote in order to get their fill,'' New York-based Avramovic wrote in a note to clients. ``However, as we've seen that volumes are lower, there are fewer bids and offers in the market which means less quote competition.''

Protection

Hedge funds often protect against drops when they purchase stocks and bonds by making the opposite wager. Investors who wanted to buy financial stocks and also hedge the trade with a short sale couldn't while the ban was in effect.

``There's a lot of long-short asset management programs out there and a lot of them have struggled since the elimination of short selling,'' said James Paulsen, who helps oversee $220 billion as chief investment strategist at Wells Capital Management Inc. in Minneapolis. ``It's hard to find stuff to short. You can't find it or you legally can't.''

The SEC took on short selling after John Mack, CEO of New York-based Morgan Stanley, and Senator Charles Schumer, a New York Democrat, blamed the practice for driving companies toward collapse. Richard Fuld, CEO of New York-based Lehman, blamed short selling in testimony before Congress on Oct. 6 for stoking a ``storm of fear'' that drove the securities firm into bankruptcy last month.

Volatility Trading

Investors are betting that volatility will decrease. Options on the CBOE Volatility Index, which measures the cost of insurance against S&P 500 declines, imply it may drop 44 percent in two weeks. The cost of an options ``straddle,'' a strategy that involves buying a call and a put of the same price and maturity, is $10 for this month's 42.50 contracts, which expire Oct. 22. The VIX ranged between 16.30 and 57.53 in 2008.

``You could see the VIX back below 40 next week,'' said Jeremy Wien, a VIX options trader at Societe Generale in New York. ``There aren't any illusions about starting a bull market in the next two weeks, but volatility could come in because it's so high.''

Restoring short selling may improve market stability by reopening a venue for investors with negative opinions on companies to bet against them, said James Dunigan, managing executive of investments at PNC Wealth Management in Philadelphia.

``With the absence of the one side of that trade, that has caused some dislocations,'' said Dunigan, who helps oversee $66 billion. ``Having the ability to implement strategies, including short selling, will lessen the volatility that we're seeing.''

To contact the reporters on this story: Eric Martin in New York at emartin21@bloomberg.net; Whitney Kisling in New York at wkisling@bloomberg.net.