Thursday, December 29, 2005

How shorting against the box can hurt

There's a fairly good chance that the sell off since our 12/06/2005 vote to allow the NYX deal to close, can be largely attributed to seatholders -- that will receive ~80,000 shares of NYX within a month or two -- who are selling AX short.

The rationale is that since there will be lock-up requirements imposed on the NYSE-turned-NYX shareholders, why not sell the stock short now and use some of the 80,000 shares to cover if necessary. It's an arbitrage play -- and a pretty obvious one.

But, here's the thing. Tax law changes from 1997 can treat profits derived from these short positions (or tax advantages derived from these short positions) as short-term gains. And, short-term gains are not typically desirable for investors (see this article).

The pressure that's been put on AX shares since the deal's approval represents "artificial selling." However, in the stock market, a sale is a sale is a sale.

While the giddy NYSE seatholders lock in their impressive gains, little retail investors may get burned. It's hard to squeeze a short that's got 80,000 shares to cover with. And, if 1366 seatholders sold 80,000 shares short, that'd be 109,280,000 worth of shares being sold.

Of course, we know that the aforementioned hypothetical situation is not happening, but even a small fraction of the 109,280,000 will put extraordinary pressure on AX shares.

And, unlike typical short covering, when these short-sellers go to cover their short -- they don't need to actually purchase stock -- they own it already!

This phenomenon helps to explain the spike in daily share volume since 12/06/2005. It also explains why seats are selling for ~$25k below their all-time high. This arbitrage strategy is attractive to some investors with deep pockets.


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