I sell you something I don’t have. Do you agree? – This doubtful trading practice, called short selling, takes place every day in our financial markets. It is highly speculative and has even been accused for fanning the flames of the financial crisis.
Last week olexa5 introduced you to short selling and highlighted some benefits. This trading strategy, however, involves selling a security that is not owned and thus has a high risk potential. A short seller speculates to profit from a price decline, as he intends to buy the security at the market for a lower value than sold, olexa5 explained. My aim is to show you the other side of the story and the threatening effects short selling can have on our financial markets.
While covered short selling, implying shares are borrowed before they are sold, may contribute to an increased marked efficiency as olexa5 outlined in her post, naked short selling on the contrary, could have a destabilizing effect and increase price volatility.
When no borrowing is involved, the number of short sold shares may even exceed those in circulation increasing the risk of a so-called short squeeze. Having a large number of short sellers try to cover their position at the same time can drive up the price of a security enormously as it was the case with Volkswagen in 2008 where virtually no freely floating shares were accessible, a Deutsche Bank research study shows.
A different issue involved with short selling is the abuse and manipulation of markets, for instance, by deliberately spreading negative rumors to profit from declining stock prices. Short sellers are even suspected to have made millions from the U.S. market collapse as well as from the Greek crisis, the column “Who’s Behind the Financial Crisis?” claims.
An article in stockexchangesecrets explains, short selling also provokes a vicious circle. Intensive short selling of a security can cause a price drop letting other investors doubt their holdings. Eventually they also sell, pushing down prices even further.
Zubi Diamond, author of the book, Wizards of Wall Street, heavily criticizes short sellers as they bet on a decline or even collapse of a stock or country and additionally have a collective power to attack that particular asset to their advantage. “If this is not organized crime, I do not know what is.”, he is quoted in “Who’s Behind the Financial Crisis?”.
Despite the risks attached, especially to naked short selling, governments did not agree on common regulations. Current laws show limited effectiveness as Investors can simply avoid rules of one marked by trading on another.
While covered short selling may be acceptable and even beneficial for the market I share the opinion that naked short selling is nothing but dangerous. A harmonized set of regulations is strongly required including the implementation of disclosure rules to increase market transparency and stability. We can only hope for a greater consistency tomorrow than it is today.