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January 1, 2003

Betting on the Bears,Traders Feast on the Weak

By Tom Taulli

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  • Betting on the Bears,Traders Feast on the Weak
  • Page 2

William Fleckenstein, whose hedge fund is six years old, misses going long.

"The valuations in equities were insane," the exasperated veteran money manager told Traders Magazine. "I would like to go back to the long side but I won't until things come back to reality." .

Even in this bear market, short selling is not easy. "There are many traps," Fleckenstein said. "You need to be a disciplined trader. There's been an explosion of money into long-short hedge funds. It contributes to volatility and it makes my job difficult."

Short selling has a long and controversial history. It has been a mainstay of equity markets, dating back to the Dutch in the 1700s. For the most part, short selling has been the scapegoat for crashes and panics. Even on September 11, rumors spread on trading desks that Osama bin Laden and his notorious al Qaeda had shorted the airline and insurance stocks.

The Regulators

Since the 1930s, short selling has been closely regulated. One example is the uptick rule, which prevents the short sale of a stock whose price is falling. "The uptick rule is slightly easier to deal with because of decimal pricing," said Herbert Arnett, the head trader at the Templeton Global Long-Short Fund. "The reason is that it only takes a one penny move up to allow for a short sale."

But federal regulations makes it difficult for mutual funds to short stocks. The mostly unregulated hedge funds, however, have stepped in to take up the slack. Hedge funds, no longer for the super rich searching for off-shore secret enclaves, are attracting more money from retail investors though the performance has been mixed.

Recent rule changes lowered hedge fund minimums making them mainstream investments. It is not uncommon to see hedge fund managers tout stocks on CNBC or the Wall Street Journal. Indeed, many top mutual fund companies - Franklin Templeton and Fidelity are good examples - have their own hedge funds.

But what if a mutual fund at Fidelity is buying a stock that is shorted by one of its own hedge funds? Is there a Chinese Wall? There is little guidance on the matter but some firms are finding solutions. At Franklin Templeton, for example, there is a centralized system that allows a first-in, first-out approach to dealing with short and long positions.

The biggest risk for a short seller is the potential for unlimited loss. On the one hand, the most a short seller can make is 100 percent. But, what if the trader shorted Microsoft after its IPO? It would be a disaster. Actually, during the roaring 1990s, many short funds simply closed down because of the massive losses.

A surge in the stock price can be magnified by short positions - known as the "short squeeze." In a short sale transaction, the trader sells the stock first and then later buys it back, hopefully at a lower price (thus covering the position).

Tom Bardong, senior vice president in charge of global equity trading at Alliance Capital, views short selling as "latent buying." If many short sellers cover their positions, it adds more fuel to the demand.