Wednesday, September 24, 2008

A Quick Take On Short Selling

What is it? Who does it? Why do they do it?

Short sellers hold margin accounts. These accounts have money in them which is used like collateral during trades. Short selling gives a trader the ability to borrow stock on margin, sell the borrowed stock at a high price, purchase it back at a low price, and pocket the difference in value. The lender of the stock, often a bank or broker, can receive interest from the collateral money in the margin account backing the trader.

Naked short selling is the practice of selling stock at a high price without borrowing it, repurchasing the "stock" at a lower value before the delivery date, and the pocketing the difference in value.

The difference between these are that the Naked short sellers never have any security, borrowed or otherwise, behind their trades. They only have the promise to deliver the security if they do no repurchase it.

Short sellers can provide liquidity in a market by providing a ready market. They will purchase stocks when others are selling and they will sell their shares when others are buying. When short selling is banned, it may be more difficult and costly for a buyer or seller to find a counterpart willing to take that position.

The short sellers can cause the current market price for a stock to go down because of their sales. When a lot of short sellers are in the market around a particular security, they can influence the actions of traditional investors and other traders. These investors don't know why the price of their stocks are going down, only that the price is dropping. This can entice some investors to sell their actual stock.

Short sellers can often make money by betting that the markets are going down, but they will lose money if they guess wrong and the markets go up.

I'd like to thank my friend Paul Pace for giving me this topic idea for my blog post.

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