How Does Short Selling Affect the Market

How Does Short Selling Affect the Market

How Does Short Selling Affect the Market

Before embarking on a discussion on how short selling affects the market, it is important to clarify what short selling is.

Short selling can be defined as "the practice of selling assets, usually securities, which have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender." In other words, the short seller benefits from a decline in the value of the assets between the dates of selling and repurchase. (Note: There are some costs associate with borrowing the assets and paying any dividends declared on those assets within that period.)

On the other hand, if the assets increase in value, the investor loses money. This is because, unlike earlier, he will have to spend more to acquire those assets than he got by selling them. This strategy of "shorting" or "going short" is the exact opposite of the strategy of "going long" where the investor profits from an increase in asset value.

There is another version of short selling, an extreme version if you will. It is called "naked short selling". This is "the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale". Naked short selling has been illegal in the US since 2008.

Now, since short selling is posited on asset prices falling, the practice has often been blamed for stock market crashes. The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, precipitating a major banking crisis which included the collapse of almost every private bank in Scotland and a major cash squeeze in London and Amsterdam, the leading financial centers during those days.

One of the earliest such instances on the US was the Wall Street Crash of 1929 which led on to the Great Depression. This led Congress to enact the uptick law banning short sellers from selling shares during a downtick the short had to be either at a price above the last traded price of the security, or at the last traded price if that price was higher than the price in the previous trade. It remained in effect till 2007.

In September 2008, a flurry of short selling, especially naked short selling, contributed to excessive market volatility, leading to a three-week ban on shorting for 799 financial companies. During this period, Germany, Ireland, Switzerland and Canada banned short selling leading financial stocks, and France, the Netherlands and Belgium banned naked short selling leading financial stocks. Australia went for a complete ban on the activity.

The stock markets are not the only ones affected by short selling. The collapse of the Dutch tulip market in 17th century and the "breaking" of the Bank of England by George Soros when he sold short more than $10 billion worth of pounds sterling are also examples of the extreme effects of short selling.

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