Short-selling or "shorting" is the practice of selling a financial instrument that the seller does not own at the time of the sale. Short selling is done with intent of later purchasing the financial instrument at a lower price. Short-sellers attempt to profit from an expected decline in the price of a financial instrument. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the opposite: an investor makes money only when a shorted security falls in value.
Short sellers are widely regarded with suspicion because, in the views of many people, they are profiting from the misfortune of others. Some businesses campaign against short sellers who target them, sometimes resulting in litigation.
However, the people advocating a ban on short selling ignore that fact markets by defination go up and down. Markets are not "meant" to always go higher. Thus, short-selling is an integral part of any market. Also, securities that have been sold short have to be "covered" i.e. bought back. Thus, in rapidly falling markets one of the most important "buyers" are short sellers who are trying the buy back the securities they have short-sold.
Importance Of Short Selling
- Restrictions on short-selling disturbs the markets price discovery mechanism. Analysis of market data has proved that shocks in which short positions were present had lower impact cost(defined by the difference between the bid and offer prices) compared to similar stocks with no short positions.
- Many trading strategies like "convertible arbitrage", "statistical arbitrage" (or "stat arb") or the typical "long-short" strategies depend on having the ability to short-sell. Noted investor Warren Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.
- Viability of the options market (without shorting, an options desk cannot run a delta neutral book - it has nothing to do with being bearish or bullish on the stock in question)
- Mutual Funds, Pension Funds and other institutional investors have stock loan desks which lend stock to short-sellers to earn return on idle securities
Anyone who seriously thinks that the cause of the current crisis is the actions of evil and manipulative speculators lacks the insight and knowledge to be allowed anywhere near the regulation of financial markets. Short selling may well exacerbate existing problems, but it certainly was not the cause.
The stock market witnessed a sell-off on Friday with the BSE Sensex closing below the 10000 point level for the first time since July 24, 2006. It took 484 sessions for the Sensex to climb from 10000 to its all-time high of 21207. However, in just 191 sessions all the gains of the last 2 years were erased.
What can be expected going forward? Is there any respite in sight? During times like these, it helps to look back at previous bear-markets. As they say, those who don't learn from history are destined to repeat it.
Analysis of previous bear-markets suggests that bear-markets take a minimum of 12-18 months to complete. Measured from January 2008, we are just in the 10th month. So, it will be atleast 6 months before stocks start recovering. I guess the price-wise damage is nearing an end. Historically markets bottom-out at 9-10 forward PE multiples. Considering 2009 March Sensex EPS estimate of 900-950, we are near the bottom.
Investors(both old and new) should use the next 6-9 months to build a portfolio of stocks which they should be prepared to hold for 2 years at least. This strategy is sure to yield returns in the long-run.
