Friday, September 19, 2008

Short Selling Explained

The collapse in share prices of Lehman Brothers, Morgan Stanley and HBOS has led to an intense scrutinisation of the practise of short selling.

Short selling means you borrow a stock and sell it immediately. The hope is that the share will fall in value meaning that you can buy at a lower price than you sold it. And then give back the stock you borrow and make. A similar effect can be had with an option known as a put. This is simply the right to sell an asset at a given price. Thus if it falls you can sell at a price above the market value.

For example, suppose you think Lloyds TSB share price is overvalued at 335. You could enter into a short selling agreement. You would borrow say 1,000 shares from a broker and then sell them for 335. £3,350. If the share price falls to 200p. You can buy a 1,000 shares for £2,000 and give back the shares you borrowed and make £1,350 profit.

Furthermore, if you spread the odd rumour about the risk of the company, you will help to push it down. Also, if the market sees many people are holding 'short' positions, then this is likely to push the share price down. Therefore, holding short positions can be a powerful way to magnify the downward movement in share prices. It is said that short selling played a role in the troubles of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Morgan Stanley and Goldman Sachs, as well as Europe's Halifax Bank of Scotland and Fortis NV.

Naked Short Selling. This is when you sell shares, you are not even sure you can borrow.

Regulation on Short Selling. There used to be a rule on Wall street where you could not hold short positions during a fall in share prices. This was known as an uptick rule. It meant investors could not pile into short positions on a share price in freefall.
Interestingly the US SEC Securities and exchange committee abandoned the uptick rule because they felt it was a constraint on market liquidity and did little to avoid manipulation.

However, many investors argue that the removal of the uptick rule has allowed hedge funds and investors to exaggerate any downward movement in share prices creating additional uncertainty over future share prices.

Will Stopping Short Selling Solve the Problem?

Short selling is really symptomatic of the problem rather than the cause. Stopping short selling will do nothing to alter the fact the global banking system is illiquid and short of funding. It will not stop banks going bankrupt. However, short selling can exacerbate problems creating additional uncertainty and volatility at a time when confidence is important.

1 comment:

Anonymous said...


Due to recent events, the concept of short selling has been explained here and elsewhere, however, one thing that I don't understand is why driving the share price down necessitates an immediate bail-out or a merger of a bank.

Surely unless the bank has an immediate need to raise capital by issuing shares, it could just sit out the period of short-selling? I understand that low share price makes a takeover more attractive, but many such takeovers appear to be more a result of encouragement by government.