A long story about a short position

– The doubtful transaction of short selling –

Even during a financial crisis there are two sides of the same coin. The beast ruining countries, families and making people homeless; but the beauty seems to be forgotten quite often. These situations also enforce a cleansing from all the financial instruments making difficulties.

One of these instruments spoken about in the media is short selling.

Short selling is the „[…] selling of a security that the seller does not own. […] Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short“ according to Investopedia.com. Consequently, the short seller is betting on falling prices (conditions of a bear market) and exactly this is what makes the public so angry. For more critics read vivipre’s next blog on the risks of short selling.

To cover the basics: the short position includes two steps reported in a Deutsche Bank research protocol
1.    Sale of borrowed security for market price
2.    Covering the position again, which means buying back the security for the current market price (favourable lower than sold)
Speaking of a naked short position implies that the security is not backed by borrowing one and can have a threatening effect on the market.

Additonally, caution should be taken when calculating the conditions in which a “short” will bring a yield, as one ought to deduct the following costs: borrowing fee, ownership claims, for example dividends paid during the period when the security is lent.

In praxis, one would open up a margin account to trade a short and thus one will have to be familiar with the margin rules attached.

First of all, one of the main reasons for including this intrument is the hedging against losses from other deals as well as falling prices of fractions in bundled securities (e.g. funds). Secondly, short selling with a speculative intention is probably the criteria making this instrument doubtful.

Before we satisfy your interest for the down side of this transaction, I would like to introduce you to the aspects usually not mentioned in the press.

In the case of the Enron scandal, if it wasn’t for the short sellers, distortions of the market and of the way companies like to show themselves will more likely stay undiscovered. Brokers specializing in these trades are well known for doing the most detailed high quality research in the business.

Further, the efficiency of the market is higher, as short selling reasons a higher supply of securities and so absorbs price bubbles.

A higher liquidity through putting borrowed securities on the market helps to overcome the gap between the price at which it was bought and the one at which it was sold. Otherwise, sellers would have a hard time finding buyers at falling prices.

Overall, a phrase cited in the German tagesspiegel.de expresses the up side of short selling in a very thoughtful way:
a market without short selling is like a democracy without a free press.

Before you leave a trace of your opinion on this post, please be patient until you get the chance to read what vivipre posts coming up soon.

This entry was posted in Financial crisis and various bubbles to be continued and tagged , , , , , . Bookmark the permalink.

5 Responses to A long story about a short position

  1. barke says:

    Cui boni? I still don’t see how anyone profits but the ones short selling. Enron still failed, market bubbles still come up and the “most detailed high quality research” is not made public (hence I find the comparison to free press a bit ironic). In the article you quoted it says: „Es hat noch nie auch nur den kleinsten Beweis dafür gegeben, dass Leerverkäufe der Grund für einen großen Absturz an den Märkten waren. Deren Anteil an der gesamten Marktaktivität ist zu klein.“ So if they are not significant, how can they absorb price bubbles.

  2. stuerzele says:

    Very interesting topic, thanks for the post!
    I am looking forward to vivipres post.

  3. Pingback: Anticipating risks in 2011…but can we? | BraveNewFinance.

  4. Pingback: A long story about a short position to be continued | BraveNewFinance.

  5. olexa5 says:

    To be added:

    A very recommendable book to this topic is ‘The big short’ by Michael Lewis. For a review by Felix Salmon go to Barnesandnoble.com. Furthermore, for a detailed discussion visit the blog from reuters.com.

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