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You might like my 2017 epic release: Trend Following: How to Make a Fortune in Bull, Bear and Black Swan Markets (Fifth Edition). Revised and extended with twice as much content.

8 thoughts on “Deep Capture

  1. Very interesting. Plenty is wrong with our financial system, but I don’t think naked shorting is even close to the top of the list.

    My issue with “naked” shorting is that so long as you have someone out there willing to lend stock, you can theoretically put as on as large a short position as you want. This is assuming that you’re clearer is willing to play ball, which Byrne seems to imply is not a problem. Think about it, if I am a short seller, and I sell 100 shares to mutual fund A, and mutual fund A makes those 100 shares it now owns available to borrow, I can reborrow them and sell them again. So long as whomever I sell to makes the shares available, this can go on forever. What acts as a check on this process is that my clearer, if it possesses any instinct of self-preservation, will not allow me to take on infinite risk.

    Another question- In the futures market, I can buy or sell as many contracts as I desire (again, with the blessing of my clearer.) I realize that eventually I’ll have to deliver whatever I’ve sold, but in that time, couldn’t I “flood the market” until the “vicious death spiral” kicks in and buy it all back? Every time in history someone tries to get larger than the market (Hunt Brothers, Brian Hunter, etc.), they usually wind up getting cleaned out.

    This entire problem (if it is a problem) could be solved by making all short-selling illegal, and creating a single-stock futures market.

  2. I have been following this for almost a decade and it is actually the primary reason I became a trend follower. Trend following still works even if share counts are invalid or the total amount of whatever you are trading is unknown.

    Fundamental analysis metrics like earnings per share based off a set number of shares get ruined by this type of corruption.

    Actually trend following might even work better because of naked shorting as up is still up and down is down. If/when someone unloads counterfeit shares then down is just… more down.

    cy: time is the problem here. If I can sell unlimited shares the price is going to go down. If I don’t have to deliver shares or locate what I am borrowing for a period of time T3+ then my trade will be successful during that period.

  3. three-

    If you sell unlimited shares in hopes of profiting, you’re going to have to buy those unlimited shares back at some point. Presumably, whatever effect your sales had on share price will be completely offset by the effect of covering the short position.

  4. cy: you don’t need to cover if you run it to zero like LEH BSC or GE… which by the way all made lower lows and trended down on their way to 0. Even you do cover you are still triggering stops and creating margin calls on holders or hedging with options. It’s not fun to be a buy and holder while this is going on. It is wealth redistribution and another type of taxation. The more you look into it the deeper it goes and naked shorting is really just one weapon and a small part of a big picture.

  5. Given all we know about the companies you’re talking about (LEH, BSC, GM (I’m guessing this is what you meant)), it should be clear to everyone that these companies had liabilities that far outran their assets. In others words, they had negative capital. In other words, they were bankrupt. Can you really look at the balance sheets of these companies and tell me you’d pay anything for them?

    If its that easy and lucrative to run an otherwise healthy company to zero, why haven’t these guys done it to every single company?

  6. cy: Lions go for the weak zebra. If they ate every zebra they would starve. Or if you ran a casino you wouldn’t have zero payout or no one would come back.

    I don’t want to argue about if FTD exist or if they are bad or good. You aren’t gonna change my mind and I doubt I would change yours. My point was that I believe these lions exist and it is why I started using trend following… so I don’t get eaten. If the herd is running one way I am not gonna go out by myself in the other direction. I try to stay right in the middle.

  7. I agree all of american companies’ balance sheets are upside down. There are plenty to run into the ground at the right time. The $700 billion is being used to keep the market afloat right now.

  8. We are not talking about arbitray short selling. This is predatory in nature, contemplated and coordinated.

    It doesn’t take a lot to destroy a perfectly good company. A news article in WSJ, sell recomendation on MSNBC and an initial attack of FTD or NSS on %5 of outstanding shares. The companies on the way down. That one drop of blood signals the other sharks to NSS and FTD further driving down the price of the stock. The more the NSS the more price drops, the more they profit. Its a vicious cycle.

    How does it work? “Married Puts”. Normally, a hedge fund buys from a market maker a certain number of put options—the right to sell a stock at a specified price at a specified date. If on that date the stock has lost value to the point it is below that specified price, the buyer of the put option (the hedge fund) makes money, and the seller (the market maker) loses money. To hedge the risk that he might lose money, the market maker, at the same moment that he sells the put option, also short sells the stock. This is perfectly legal.

    But some market markers conspire with hedge funds to drive the stock price down. Instead of merely shorting the shares into the market, the market maker naked short sells the shares, and, importantly, sells those phantom shares to the same hedge fund that bought the puts. As a result, the hedge fund manager winds up with the puts and a matching number of shares (actually phantom shares that are never delivered to him, but about which he never complains, or forces delivery, as that would create upward pressure on the stock, the precise opposite of what he wants). Because the puts and the phantom shares are equal in number and arrive together at the hedge fund, they are known as “married puts”.

    Once in possession of the phantom shares, the hedge fund manager proceeds to fire them into the marketplace. But he is able to say that he never naked shorted because all he has done is sold the shares that he bought (wink wink) from the market maker.

    Either way, the effect is to flood the marketplace with phantom stock. The hedge fund makes money. And the market maker is rewarded with more business selling married puts.

    Incidentally, the fee charged for such puts do not follow any normal option model pricing (in fact, the exchanges search for married puts by looking for options that are mispriced in relation to Black-Scholes, the standard formula that prices options). That is because their pricing is not really a function of any math or statistics, but is a function of the willingness of the hedge fund to pay the option market maker to help him break the rules against naked short selling. And that willingness is a function of how difficult it is for the hedge fund to use other loopholes to break those rules.

    In the slang of Wall Street, these married puts are known as “bullets.” Through their maneuverings, the option market maker and hedge fund manager synthesize a naked short position that puts “bullets” into the hands of the hedge fund. The hedge fund fires those “bullets” at the stock to make it collapse, timing the last “bullet” to fire as the hedge fund’s put option expires profitably. If the option position nears expiration and looks like it will expire at a loss (“out of the money”), the hedge fund manager goes back to the option market maker, and together they reload by synthesizing more “bullets.”

    Until recently, this behavior flourished owing to the “Madoff Exemption” – a rule that the SEC named after a “prominent” market maker and investor named Bernard Madoff. Mr. Madoff had considerable influence at the SEC, and helped the commission write the rule that carried his name. This was before Mr. Madoff became famous for orchestrating a $50 billion Ponzi scheme with help from the Mafia (CNBC’s Charles Gasparino has reported that Madoff might be tied to the Russian Mafia; whistleblower Harry Markopolis stated in Congressional hearings that Madoff appeared to have ties to the Russian Mafia and Latin American drug gangs; and Deep Capture’s own investigations suggest that Madoff did business with multiple people with ties to both Russian and Italian organized crime).

    The “Madoff Exemption” permitted market makers (e.g. Madoff) to sell stock that they did not possess, so long as they were doing so temporarily to “maintain liquidity.” Abusing that exemption in order to facilitate naked short selling in cahoots with hedge funds looking to drive down stock prices was blatantly illegal, but the SEC looked the other way, even as market makers failed to deliver shares for weeks, months, and even years at a time. If anyone raised a fuss, the hedge funds would say that the phantom shares didn’t originate with them, the SEC would say that stock manipulation is hard to prove, and the market makers would say that they weren’t breaking any rules.

    After all, they had a “Madoff Exemption.”

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