Government Makes Move to Prevent Market Meltdown

The Bush administration is looking at all angles to try to avoid a further meltdown in the housing and mortgage markets. With home loan applications down 14.1% for the week of July 25 to their lowest level this year, the falloff may indicate lower demand for housing and cause additional weakness.

To try to prevent a collapse in the stocks of mortgage finance companies, federal regulators have put in place a temporary order extending to mid-August that restricts naked shorting of stocks involved in this area. This means that short sellers cannot short these stocks if they do not own them. In regular short selling, the trader must borrow the shorted stock and sell it in the market. Profits are then made if the stock sold declines, at which point the trader could buy back the stock at a cheaper price and replace the borrowed stock with profits made based on the difference.

While the move by regulators does not allow for the free movement of capital in the stock markets, it is necessary to help prevent a meltdown that could really tarnish the financial sector. In fact, this type of stock support is the kind the strategy that is needed in times of crisis.

But while the restriction will help mortgage finance companies, there are still ways to play the downside and with much less risk than naked or regular short selling. Traders betting on weakness in the mortgage area can buy put options or initiate bearish put spreads. If you happen to own mortgage finance companies and want to hold the stocks, you can write covered calls on them and generate premium income while lowering your adjusted cost base.