Selling Short

On September 19th, 2008 the Securities and Exchange Commission halted the short selling of financial stocks in order “to protect the integrity and quality of the securities market and strengthen investor confidence.” The U.K.’s Financial Services Authority took similar action the previous day, in an effort to stabilize what was at the time, a very volatile market. The action taken by the SEC froze the short selling of securities of 799 financial companies immediately.

If we associated the typical purchasing of a security as taking a bullish approach (i.e. holding a conviction that the value of that security will increase), then short selling would be the opposite, taking a bearish approach (i.e. holding the conviction that the value of the security will decline).

For example, if an investor is convinced that a certain company’s stock value is inflated, he can go to his broker, who is holding shares of that stock for another investor, and “borrow” however many shares he wants. He can then sell those shares, wait for the value of that stock to drop, and then buy then back and return them to their owner, netting himself a profit which is equal to the difference in value between what the shares were originally worth and what they are worth after the drop – minus brokerage fees and borrower’s fees of course.

The benefits and detriments of shorting a stock are essentially the inverse of the benefits and detriments of purchasing a security in the typical fashion. With shorting, you make money when the security’s value goes down, with “going long” you make money when the value increases. Purchasing a share of stock places no limit on how much money you can (theoretically) gain, while you can only lose as much as the original cost of purchasing the security. Conversely, shorting a stock will yield profits dependent on the original price of the security, while your potential losses are (theoretically) infinite.

Short selling is used in a lot of different scenarios – particularly in the commodities market – but the most common scenarios are speculation and hedging. Speculating with a short sell means that there is some indication that the value of a particular security will go down, and the stock is thus sold short in order to profit on the decline in value. Hedging works by distributing an investor’s risk, thus allowing them to protect themselves in the event that a large market movement hurts their original investment.

If you remember, the Fall of 2008 was quite a volatile time for the stock market. Investor confidence was very low, and that manifested itself through wild swings in the market. At the time, the Fed was worried about a total market destabilization, a scenario they believed was being facilitated by investors acting too bearishly, prompting the ban on short selling of those 799 securities.

The ban didn’t exactly go as planned, and its orchestrator, SEC Chief Christopher Cox even went so far as to question its effectiveness, stating in December 2008 that “knowing what we know now, I believe on balance the commission would not do it again.”

One of the unintended consequences of the ban was a sharp decrease in liquidity in the markets, and after the ban was lifted, the market resumed its steady decline, further harming investor confidence and increasing the call for more drastic measuring, including calls to shut down the markets entirely.

The ban was deemed a failure, at best having no effect on the economy and at worst harming it further than it would have been had the SEC left it alone.

-Michael