Making Money Out of Nothing at All—Short Selling Explained
One week ago, the stock market surged, Wall Street was dominated by four large investment banks, and the largest insurance company in the world was enjoying a spike in stock price.
What a difference a week makes. One week later, the market saw its worst day in eight years, Wall Street is left with only two stand-alone investment banks, and the once largest insurance company in the world is fighting for its life. If you fell asleep at your desk last week and just awoke, I’ve got some news for you: the world has changed.
So what happened? Well among other things, companies have now been thrown to the market wolves, or bears in this case, and left to fend for themselves. Essentially, short sellers have taken hold of financials and continue to drive the market lower. How did so few become so powerful? Let’s consider the dynamics of short selling.
Short sellers make a bet that the price of a company’s stock will fall. To do that, they borrow shares of a traded stock (usually held by a brokerage house), and sell it with the intent of buying it back at a lower price. When the price drops, the short seller can buy the stock back and earn a profit on the difference between the sale price and the purchase price. Of course, if the price of the stock goes up, the short seller may have to close the position by buying shares of the stock to replace the borrowed shares at a higher price thus recognizing a loss. For example, a short seller sells shares of Lehman, the most recent market casualty, short at $4 per share. When the share drops to $.10 after the bank declares bankruptcy, the short-seller buys the shares to replace the borrowed ones at $.10 earning a $3.90 profit. Of course, had the stock gone up to say $10, the short seller may close the position by purchasing the shares at that price suffering a $6 loss.
Short-sellers are as much a part of an efficient market as the people who buy and hold shares of stock for an extended period of time. Unfortunately, the rules governing short-selling allow for short-sellers to push a stock to unprecedented lows in a very short period of time. This has created two contentious points:
1.) The SEC’s standards for enforcement of “naked” short-selling are lax. Naked short selling means someone can sell short without even borrowing shares. In theory, it can allow a large short sale order to be placed which in and of itself, could push the stock price lower. As more, larger sell orders are placed, a stock price will collapse.
2.) The uptick rule required that a short sale must be entered at a price higher than the last trade. The idea behind this is that it prevents the compounding downward pressure of progressively lower sell orders. The uptick rule was eliminated in 2007.
Short selling adversaries argue that there is a lack of regulation allowing for short sellers to essentially gang up and beat a stock down to nothing. Unfortunately, a falling stock price, while a technical problem, can easily become a fundamental problem in sectors such as financial services and insurance. In these sectors, a drop in stock price can trigger a ratings downgrade which can prompt liquidity concerns. If these issues are not checked, a complete collapse of a company can occur.
To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.