Understanding the current financial crisis necessitates picking up many new financial terms. “Short selling” has been one of the frequently used terminologies you may have heard as the news struggles to keep up with all of the opinions for explaining what is happening in the market. I thus found it appropriate to write toda‎y’s article about the definition of a short sale and attempt to uncover what all the recent fuss is about.

Normally when people think of the stock market they imagine buying stocks and holding them, hoping for their values to appreciate over some desired term. This old-fashioned strategy has its merits given that the stock market as an aggregate has consistently risen over the last century. But what about if you think a company’s stock price is actually going to decline?

Introduce the short sale. It is the tool designed to do precisely what our foreseeing investor was desiring; betting on a stock’s price falling. How does this work? First, an investor arranges to borrow a particular security with the intention of returning that security at some future date. He then would immediately sell the share on the market for it’s current value. The next step would be to repurchase the stock when the timing is perceived opportune and return the share to the borrower pocketing the difference, assuming the price went down. Now, keep in mind that the short seller has unlimited risk on the upside because technically the stock’s price could rise to any amount and he would have to buy the security at the inflated price to replace the original that he purchased.

Ok, so we have the mechanics of how the short sale actually works but what is all the fuss about anyway? According to some, the short sellers were taking advantage of the failing investment banks by strategically pushing bad news about the companies to further depress their values. Some investors or institutions went as far as going short but not actually borrowing the underlying securities and thus were becoming involved in what is known as naked short selling. This is not always illegal but sometimes there is no intention in actually borrowing the asset but instead to make a direct attack on a firm’s stock. This is illegal and further steps were made last week to insure that borrowed securities are delivered within a definite time period. Failure to comply will result in a penalty.

Witnesses to market crashes throughout the decades have consistently placed the blame on short sellers but are they at fault? Many say that they only expediate the fall not initiate it and that short selling actually makes the market more efficient and adds liquidity. Some keen short sellers are also very adept at pointing out inadequacies or fraudulent practices within firms making them a useful check on keeping the system honest. Regardless of these opinions last week the SEC decided to place a ban on shorting 799 specific companies in the hope that this would protect some of the weak companies from further onslaughts. Was this the correct decision or will this lead to further market disequilibrium? I will leave it to you reader!

I hope you enjoyed today’s article
-Quentin