Traditional investing is all about buying low and selling high. Regular trading involves people who want their shares to go up.
Short selling is the opposite. It involves people who want the share price to go down.
With short selling the concept is to switch the two transactions and sell high first followed by buying back later at the lower price. It's basically old fashioned investing, except in reverse.
It's hard to do unless you have the stock first and that's where securities lending comes in.
So the process often goes like this:
Covered short selling is the above scenario where stock is borrowed before the short selling occurs.
Naked short selling however does not include the borrowing of stock.
Short sellers can accelerate the decline in share prices. We saw Enron, WorldCom and Bear Stearns deteriorate rapidly after short sellers discovered problems.
In Australia, ABC Learning Centres, Babcock and Brown and Allco have all been targets.
Businesses don't like it when targeted by short sellers as it usually means an acceleration in the decline in share price.
Defenders of short selling say that they don't cause share prices to collapse but merely accelerate something that was going to happen already.
In the US on 19 Sept September short selling on 799 financial companies was banned. The ban will stay in force until October 2.
In the UK on 18 September short selling on 29 financial companies was banned. The next day, another 4 companies were added to the list. The ban will stay in force until 16 January 2009.
In Australia on 21 September ASIC announced its concern that current market conditions coupled with extensive short selling is causing unwarranted price fluctuations and subsequently banned short selling on shares in Australia for 30 days (with a few exceptions).
Short selling is not a new phenomenon. The Dutch were the first to ban short selling in 1610, around the time of the tulip speculative bubble.
England banned short selling in the 17th century when it realised that the South Sea Company had falsely inflated its own price.
Short selling was happening in 1929 when the stock market famously crashed in the US.
More recently short selling was blamed for speeding up the Asian financial crisis in the late 1990s.
One consequence of the ban on short selling is that volumes on the market are expected to be lower. That means lower liquidity and potentially more volatile moves.
It's a worry for hedge funds that use short selling in their strategies.
It's also a worry for traders who use short selling as part of their strategy or risk management strategies.
For normal investors, hopefully it means that the regulators have put in place precautions to help stem the extreme volatile market moves.
Happy investing!
Julia Lee Equities Analyst Bell Direct
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