Short-selling Stocks

(http://www.tradedecider.com/user/blogs/TD%20Blog/2010/01/26)

By Corinne Speckert, TradeDecider.com

Written on January 26, 2010

Short-selling is overwhelmingly thought of as negative by many investors, financial institutions and by the U.S. government – and, it's now without reason. Despite benefits associated with this trading method, short-selling and its counterparts have had their fair share of controversy.

The practice of short-selling has recently been caught up in a battle of tug-of-war. Critics argue it has forced share prices down and destroyed market confidence, while proponents hail it valuable – claiming it ensures the accurate portrayal of stock prices in relation to investor demand.

So, which way do you go? In this article we'll discuss the fundamentals of short-selling and then we'll get to its pros, cons and the current regulations facing it.

Short-selling is the selling of a borrowed stock that has an anticipated loss in value, so the trader can sell it at a higher price and buy it at a lower one – keeping the monetary difference generated through the exchanges.

When short-selling was first approved by the Securities and Exchange Commission in 1938, it was thought to benefit the market, but after the U.S. government needed to bail out numerous major financial institutions in 2008, its popularity dwindled as banks and companies claimed it contributed to heavy declines in share prices.

Among some of the institutions opposing short-selling is the investment firm, Lehman Brothers, who, after taking a hard hit during the mortgage crisis of 2007, claimed that short-sellers had spread rumors to drive down their stock's price – ultimately, leading them to file for bankruptcy in September. Although it is impossible to confirm the validity of the Brother's claim, it is also very likely.

Short-selling has many benefits – such as, providing markets with extensive information by evaluating market downtrends – and it also has downsides, as it can be used to manipulate share prices by crooked traders. This method, named the “short and distort” by its Wall Street users, capitalizes on rumored misfortune and a bear market in attempts to manipulate stock values.

The short and distort method is essentially a smear campaign lead by short-sellers who spread rumors of loosing shares in attempts to bestow fear in holders by distorting a stock's true value. This allows traders using this method to sell the rumored stock at a higher price and then – after devaluing it through false information – to buy it back at a lower one.

The panic caused through the short and distort method sequentially leads to heavy looses by slandered financial firms, as well as average day, swing and long-term traders who falsely sold their stocks and therefore missed out on its potential profit.

Another controversial technique associated with short-selling is naked short-selling, which the S.E.C marked as illegal in July. Naked short-selling is similar to the original, except traders don't determine that a stock is borrowed before selling it. This saves short-sellers from fees associated with borrowing and allows them to manipulate stock prices by disregarding a stock's normal supply/demand pattern.

In attempts to counteract and regulate the negative effects associated with short-selling, the S.E.C adopted regulation SHO in 2005. In 2007, the S.E.C further amended this measure to include naked short-selling in order to eliminate existing loopholes enabling its illegal use. An outline of SHO regulations can be found at www.sec.gov/spotlight/keyregshoissues.htm.

Despite regulations, which Wall Street and Congress say have helped curve manipulation associated with this method, it's still under scrutiny, as the S.E.C announced five proposals to further regulate short-selling in April and started talks regarding toughening regulations on naked short-selling in September.

Of the five proposals, one entails imposing a bid-test, which would only allow short-selling if there was an increase in a stock's last bid price. Another proposal would use circuit breakers to prohibit short-selling for the rest of the day, once a stock's price had declined by at least 10 percent.

Despite the controversy associated with short-selling, hedge funds still argue about its necessity, saying it adds liquidity to the market. The investment firm, Goldman Sachs, further argues that more regulations would only hurt investors instead of helping them.

With heavy hitters on both sides of the short-selling debate, the ultimate question comes down to: Do its pros outweigh its cons?

Basically, short-selling is helpful to traders and financial firms because they're able to receive negative news sooner. This gives them the chance to play damage control by allowing them to either sell a failing stock for a profit, or get out without too heavy of a loss.

Other critics argue that its practice – through selling borrowed stocks instead of their own – is unfair, but on the other hand, this option helps maintain the market's balance by allowing buyers to borrow shares. If short-selling didn't exist, buyers who couldn't find shares would need to increase their bids, which would widen bid/ask spreads and ultimately create a warped market with random pricing.

As the S.E.C spends the next few months determining the extent of regulations imposed on short-selling, this method's future may not be clear, but something that is inescapably apparent is the necessity of traders to protect themselves from the scandals intertwined with this beneficial, but potentially harmful method.

Note: Because of my lack of experience in financial writing, Phillip Pham, the CEO of TradeDecider, Inc., did not credit my name for these writings. Should anyone have questions regarding the authorship of these writings, please contact Phillip Pham at (408) 693-9358 or through e-mail at dtprophet@yahoo.com and philip4av@gmail.com