The Short Ban and ETF's

Since the SEC decided to follow the lead of the UK and ban short selling, this time on 799 select financial stocks, with others beginning to petition to be put on that list to protect their own shareholders. The transition into ETFs only seems logical.

For this purpose, we’ll look at the (SKF), which is the UltraShort Financials ProShares. The (SKF) managers don’t actually short the underlying stock directly; they enter into equity swap contracts with an intermediary – who goes out and shorts the stock. With the ban in place, there are less (if any) counter-parties to assume the risk on the other side of the swap contract.

ProShares made the following announcement this morning, while the ETF was halted: “Due to the emergency action announced by the Securities and Exchange Commission on September 18, 2008, temporarily prohibiting short sales of shares of certain financial companies, Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF) are not expected to accept orders from Authorized Participants to create shares until further notice. Unless notified otherwise, shares will be available for redemption by Authorized Participants as normal. The shares of these ProShares are expected to trade in the financial markets today, but may trade at prices that are not in line with their intraday indicative values.”

It has subsequently started trading again, down nearly 20% during mid-day action. Obviously, we see the inverse action on the 2x long ProShares (UYG). So, if bears really think Paulson & Company will be stuck holding a bad hand after this weekend, they can go ahead and short the UYG itself rather than even dealing with the SKF and the mess created by the ban. On the flip side, others will confide in the government and remain long the likes of the UYG and the Financial Sector SPDR (XLF).

Two questions: (1) Will hedge funds start piling in these ETFs [traditionally used by small-capital investors for the moderate-long term] with no shares of individual companies available to short? (2) Will the shorts go right back after the financials, specifically the likes of Morgan Stanley and Goldman Sachs on Oct. 2nd? We’ll wait and see- any unusual activity in the October 2008 options, as the plan from the Treasury and Congress becomes clearer, could signal the future of the financials come the 2nd of October.

Midday (2pm on 9/19/08) charts of the UYG and SKF, respectively:

I have no position in either ETF.