Madeindet:
THERE IS NO EVIDENCE WHATSOEVER THAT PIKE DID ANYTHING ILLEGAL. He bought a boatload of SPNG stock and he sold that stock at a loss. Yes, it was a very large investment. So what?
SHORT SELLING is perfectly legal, if Pike even engaged in it. NAKED SHORT SELLING is next to impossible and there is NO EVIDENCE that Pike was involved in NSS activities.
Here is a simple example (one of many) of how an investor can hedge his investment as a way to reduce risk. Just replace the word WIDGIT with SPONGE. This is a LEGAL strategy, widely employed by managers of high risk funds - which is exactly what Pike's role was in managing his fund.
Hedging a Stock Price
A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase, as he believes that shares are currently underpriced. But Company A is part of a highly volatile widget industry. So there is a risk of a future event that affects stock prices across the whole industry, including the stock of Company A along with all other companies.
Since the trader is interested in the specific company, rather than the entire industry, he wants to hedge out the industry-related risk by short selling an equal value of shares from Company A's direct, yet weaker competitor, Company B.
The first day the trader's portfolio is:
Long 1,000 shares of Company A at $1 each
Short 500 shares of Company B at $2 each
The trader has sold short the same value of shares (the value, number of shares × price, is $1000 in both cases).
If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%:
Long 1,000 shares of Company A at $1.10 each: $100 gain
Short 500 shares of Company B at $2.10 each: $50 loss (in a short position, the investor loses money when the price goes up)
The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
Day 1: $1,000
Day 2: $1,100
Day 3: $550 => ($1,000 - $550) = $450 loss
Value of short position (Company B):
Day 1: -$1,000
Day 2: -$1,050
Day 3: -$525 => ($1,000 - $525) = $475 profit
Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge – the short sale of Company B net a profit of $25 during a dramatic market collapse.
