Most of us are familiar with the concept of investing in stocks. We buy into stocks and these stocks represent ownership in the companies we invested in.
If the company performs well, more investors will want to buy the stocks that we own. At the same time, more owners will also want to keep their stocks since the company is performing well. The excess in demand and lack of supply will drive up the stock price of the company.
The reverse holds true as well. If a company performs poorly, some owners may want to sell their stock. At the same time, outside investors may be less keen to buy. The lack of demand and excess in supply will cause stock prices of the company to drop.
Regardless of how small your ownership in the company may be,
As owners of the company, our actions (rightfully) affect the price of the stock. If we do not want to sell at a lower price, stock price will not drop. These are the basic fundamentals of supply and demand that causes stock price movements.
But why are we spending so much time introducing this simple concept?
Read Also: 5 Common Investment Myths To Debunk In 2017
Did You Know You Can Sell Stocks You Don’t Own?
Imagine now that you invested in a stock that you think should do well. However you notice the price of the stock falling each day. You wonder why, perhaps other investors are aggressively selling their holdings? Not necessarily.
What if we tell you that they are traders out there who are selling stocks in the company that they don’t even own, also known as short selling. In the process of doing so, they are causing stock prices to fall.
This changes things…a lot. Not the least because the whole economic concept of willing buyers and sellers setting price in the stock market is now under threat by traders who are short selling stocks that they don’t even own in the first place.
But Why Would People Even Do That?
You see, the financial market that we live in today is extremely innovative when it comes to finding new ways of making money. Here is a simple way of understanding how the entire process of short selling came about.
The economy is doing well. People are buying stocks and seeing the value of their portfolio increase each year. Everyone is happy. Yet, there are some market participants who are convinced that the current optimism in the stock market is unwarranted. In otherwords, they think the stock market is in a bubble that may burst anytime. They are right.
What happens when the economy stops performing? The first thing that will occur is that some investors will sell their investments, intending to either take their profits or to cut their losses. Stock prices decline, as everyone starts acting the same way.
The interesting situation here is that even the market participants who correctly anticipated that stock prices will eventually crash have no way of profiting from their correct analysis, not without short selling before involved.
This is because based on the earlier scenario, an investor can only make money when the stocks they invest in go up, and not down. If you think the stock market is currently a bubble, the only thing you can do is to wait on the investment sideline and avoid making any losses. There is nothing you can do to make money. It’s just like the Singapore property market today.
Instead of only making money by choosing the right stocks that will increase in price, the main idea behind short selling is that market participants can now make money by choosing the right stocks that will decrease in price.
How Traders Short Sell Stocks
The main way of short selling a stock is to borrow it from a brokerage firm that is able to lend it. The stock borrowed has to be an actual stock that the firm owns, or by someone who has lend it to the firm.
Traders who short sell stocks will have to eventually close their position. For example, if a trader short sells a stock at $1, and it falls to $0.90 a month later, he can close the position and profit $0.10. If the price increases, he would make losses. During the time that the short position is open, interest would have to be paid on the borrowed stock. As such, short selling is seen as trading at best, and speculating at worst.
Another popular, though somewhat illegal, way of short selling stocks would be to do what is known as a naked short. A naked short refers to the practise of selling stocks without even borrowing them. A naked short essentially means traders are selling stocks to the market that they do not even own in the first place. While naked short selling is deemed illegal in most stock exchanges, they still exist due to regulatory and trading execution loopholes.
The Case For Allowing Short Selling In The Market
Short selling is not always bad for the stock market. One of the main value proposition it provides is that it helps maintain stock market discipline by preventing prices of stocks to be aggressively bid up in an unsustainable manner.
In other words, by allowing traders to profit from short selling, stock exchanges are able to use these traders and their analysis to prevent stock market bubbles from forming in the first place. Short selling also provides liquidity in the market.
The Case For NOT Allowing Short Selling In The Market
At the same time, excessive short selling can have a devasting effect on companies that are undergoing short-term challenges, but are generally still healthy in the long run.
That is because short-sellers, who we have already mentioned are not even owners of the company, can directly cause a company’s stock price to collapse through excessive speculation. A company, which is the target of short sellers, may find their stock price declining even though the bulk of their investors continue to have faith in the ability of management to turn things around. When that happens, a company and its investors are unfairly penalised by short-sellers.
Because of that, most stock exchanges take a very serious view on short selling that does not comply with regulatory requirements.
What are your views on short selling? Do you think it holds a place in our financial market today? Or should it be made illegal? Share your thoughts with us on Facebook.
DollarsAndSense.sg is a website that aims to provide interesting, bite-sized financial articles which are relevant to the average Singaporean. Subscribe to our free e-newsletter to receive exclusive content not available on our website. Follow us as well on Instagram @DNSsingapore to get your daily dose of finance knowledge through photos.