Why is it frowned upon in the market and if its so bad why were people allowed to do it in the 1st place?
What is short selling and how dose it work?
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3 Comments
There is nothing wrong with a simple short sale. It is a way to make money if a stock goes down. You sell the stock, the brokerage firm borrows the stock from somewhere else to satisfy both sides of the trade. When you close out your short position by purchasing the stock, the action is reversed. Any gain or loss belongs to you.
You can achieve the same goal by using options.
An example of an illegal short sale would be shorting a security on an ipo. There are several types of illegal short selling which is disruptive to the market.
Steve D and Heather both gave very good answers. In addition, short sellers in the past primarily looked for overvalued stocks because of overcalulated/misrepresentions in their financials. This kept the prices of stocks in a proper balance.
The problem is that the hedge funds have been unregulated. To compound the problem many are classified as offshore. To make matters worse, the SEC has not enforced trading rules so, as Heather alluded to, many illegal shorting techniques have occured.
One such method is known as naked short selling. It’s the equivalent of counterfeiting. Now combine a concerted effort by several hedge funds to target and focus on one company using negative rumors and the price per share will plummet. It no longer is a correcting value tool but a distorted momentum play.
This week you have seen the SEC step in (finally) and declare naked shorting as illegal, which it already was. Morgan Stanley showed very good financials this week yet their pps dropped about 50%. The halt on all shorting of the 799 companies tells the hedge funds that the government is now watching their every move………………again, finally.
First, short selling is not really frowned upon – in most circumstances, it is a valid way of investing and is sometimes used to hedge your bets, so to speak.
Short selling works as follows – an investor identifies a stock he thinks will go down in price. Now, if he owns the stock, he just sells and buy sit back later at the lower price, thus ending up with his original shareholdings plus money in his pocket. However, if you don’t own the stock, you can do a short sale. What that entails is technically borrowing stock from someone or somewhere (usually your investment house) and selling the stock. You then have three days to settle the trade and deliver the stock you just sold to the buyer. You then wait until the stock price drops and buy the stock and deliver the shares, making a profit.
Of course, there is a risk (usually) in that the shares could go up in price and you would have to buy the shares at the higher price, thus losing money.
The problem right now is that short sellers are selling shares of almost all financial institutes, even the healthy ones. The selling is creating excess sell supply on the market and artificially driving down share prices. In order to correct for this, the SEC has halted short sales of 799 financial institutes and is enforcing the 3 day rule on short selling settlement. This should give the market a chance to rationalize.