Shorts Squeezed
Posted on July 25, 2008
Filed Under Trading |
In recent days much has been written about “short selling”, in particular banking shares on both sides of the market. A quick reminder: short selling is being allowed to “borrow” shares not owned and betting they are likely to fall in price. When the price does fall buying them at the lower price and giving them back to the broker. The profit is in the price you sold at (ie the opening trade) and the price you buy at (ie the closing trade). This is one of the most popular “Ask Anna” questions and I am always trying to find different ways of explaining the concept. My latest attempt is given at the bottom of this post.
Problems with short selling by largely secretive hedge funds has led to the financial regulators in the UK insisting on large short positions being declared. In the US last week’s SEC’s announcement of a possible Banking Committee hearing and vague new emergency restrictions against “naked short selling” led the Dow Jones to have rallied a total of 700 points on the week. However, one rally does not a summer make - even if oil also duly obliged by falling to $128, and has continued to do so.
Text of email received from Daniel:
Hello Anna,
Short selling … A stupid question
Short-selling means selling shares which you do not actually own, but instead borrowing them from another party to “sell” on the market.
It is said that large volumes of short selling can drive a company’s share price down significantly…
How, please? … the shares are borrowed and eventually returned to the shares owner??? …
I borrow shares from a bank, sell them (the buyer never get hold of the shares), buy them back and return them to the bank …
The sale cannot actually occur as the shares are borrowed and still owned by the shares holder… or does a sale actually occur?…
How the market maker knows about it? Anyway, nothing has been bought or sold …
How can this affect the financial market (driving the underwritten price to force selling at a discount); as no sale really happens?
Does short selling through spread betting or CFD can affect the market as well, in the same way? I would say “no” as in this case it is only a bet on the price movement of a share… correct?
Now, how FSA new rules (short-selling the shares of a company conducting a rights issue have to reveal their activities…) can prevent any “damage” to the issuers in question? revealed or not, the short-selling does occur anyway …
Thank you for your time Anna
Regards
Daniel
My answer to Daniel was as follows:
The point you are missing is that whilst the shares are indeed “borrowed” from another client within the brokerage the short seller physically sells the shares and his/her account debited accordingly. The short seller hopes to buy back the shares at a lower price and pocket the profit. To put it into context and perhaps more simple terms: when you trade long your opening position is a buy and your closing position is a sell. When you trade short your opening position is a sell and your closing position is a buy. The only difference with short selling is that you are selling something you do not own.
As a short seller you are responsible to the original owner for any dividend so if a dividend is declared whilst you have sold the shares you will be liable to pay that to the real owner.
If the prices rises above the price you sold you will be forced to buy the shares back at the higher price in order to return them to their rightful owner.
Spread betting and cfd’s are based on derivatives and trading is not based on physical shares.
Hope the above helps.
Regards.
Anna
End of Answer
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