In part this will be because we all have an inherent desire to find anyone but ourselves to blame when we make an investment mistake and often short sellers of the securities in question take the brunt of this.
I should make my stand point clear here and say that I have no issue with the actual process of short selling, but I do have a particular dislike for coordinated short selling attacks based on lies, which I feel aren't as widely dismissed by the investment community as "pump and dump" market manipulation is - see Quindell plc for an example of a great company that's been trashed by coordinating short sellers.
Now, there are actually many different ways in which you can effectively bet on markets falling in price - Spread bets, Contracts for difference, etc.
How the short selling of shares works:
The easiest way to look at this is to reverse a usual share transaction (excluding commissions, tax, etc):
Let's assume that you purchased an asset for £100 and sold it for £1,000.
- Profit = £900
Now, we'll turn this around and sell our asset for £1,000 and then buy it back at a price of £100.
- Profit = £900
More specifically, it works like this:
Hedge Fund 1,000 Shares Pension Fund
or <------------------------------------------------------ or
Asset Manager ------------------------------------------------------> Large Bank
1. I borrow some shares, for a small fee, normally from a pension fund, because they have lots of shares that just sit around doing not a lot.
- By allowing shares to be shorted the pension fund can make a little bit of money effectively risk free.
2. I sell the borrowed shares into the market.
- E.G. I sell 1,000 shares (in a company of your choice) at £20 per share.
3. I buy back the borrowed shares.
- E.G. They're bought back for £10 per share.
Profit = £10*1,000 =£10,000 (excluding the pension fund's fee).
4. Return the shares to the pension fund.
Naked Short Selling:
This is the process of utilising the settlement delay on trading contracts, to make up for the fact that you're selling shares into the market that you haven't been able to borrow from anyone - it's an uncovered bet effectively.
Dangers:
The biggest danger with short selling shares is that you may not be able to repurchase them in the market if the position begins to go against you. This is known as a short/bear squeeze and can be pretty devastating, as you can lose a vast amount more than the long equivalent of the position (someone buying shares only has a maximum risk of 100%, while short sellers can risk more than this if the price rises more than 100%).
Banning Short Selling:
Regularly, people call for the banning of short selling and in 2011 four European countries did implement this temporarily regarding the stocks of major banks, but in reality this didn't work for a couple of reasons:
- A ban needs to be pretty much global or the hedge fund just move to jurisdictions where they can legally short sell.
- Also, without the ability to short sell, you suffer from a very large component of the hedging tools available to funds disappearing instantly.
- It would really need to be done on all forms of short selling (via derivatives), not just the short selling of shares.
- Banning short selling is also just inherently silly, because if a share price is falling then it's going to fall anyway - bad business practices cause falling share prices. However more importantly than this, if you remove a very large aspect of the stock markets then you're going to reduce the total amount of trades and thereby increase market volatility.
- In order for a ban to be effective it has to cover all stocks, not just sector specific ones, or it just moves short selling pressure elsewhere.
Enjoy,
The Masked Stock Trader.
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