Short selling is simply betting the per share price of a corporation’s stock will decline.  More precisely, an investor agrees to borrow a certain quantity of stock that another investor (the lender) owns with the intent to return the stock at a later date.  The borrower will then purchase shares at a point in the future to return to the lender. If all goes well for the borrower (the one attempting to short sell, or “short”), the stock price will have fallen so that they can pay the lender back with shares that cost less than the borrowed shares.  The net effect is the short seller profits in the amount the per share price declined.

Short selling is considered a highly risky practice because a stock’s share price can, in theory, rise indefinitely.  This is not the case with the inverse; zero is as far as the stock can drop.  If the per share price were to rise on a stock that you were selling short, you would lose money in the amount that the share price increased over the borrowed share price.

While it is risky, short selling is also regarded as a practice that provides liquidity to the financial markets.  “Provide liquidity,” and its various incarnations, is a ubiquitous phrase in the news, yet rarely explained by the article in which it appears, even to the point of being indecipherable with context clues.  Providing liquidity in the stock market means producing money flow.  It’s that simple.  Providing stock market liquidity is to drive market forces in influencing investors to purchase and sell stock.

Many people are convinced that short sellers are artificially hurting the financial sector through their practices.  It has been said that short sellers spread rumors and falsities to cause a negative reaction to a company they have a short position in so that they can profit from the stock’s decline.  This is probably true, and I am sure someone will come back with an exact example of a scandal coming to light, but for the time being let’s assume that it is probably safe to say that some people are greedy enough to lie to make money.  However, this only affects the certain stock in question, not an entire stock market decline.

The SEC temporarily banned the short selling of 799 stocks in the financial sector on September 19, 2008.  The rationale behind the ban is that short sellers have been and will only continue to make the financial sector share prices tailspin.  The logic of this is inherently flawed because short sellers agree to return higher-priced shares back to the lender by replacing them with lower per share price stock.  The short sellers must purchase stock to give back to the lender.  When shares of a corporation’s stock are purchased, the supply/demand ratio of the stock changes leading to a natural increase in stock price.

The connection to make here is that in a time when stock prices of financial sector corporations are plummeting, short sellers are continuously borrowing and then purchasing stock to repay the lender at various price points.  The short sellers are virtually the only investors purchasing shares in these tarnished stocks because they are more than happy to purchase so that they can “pay” back their stock lender and pocket the difference.   One could make the argument that at a time like this with stocks in a very specific sector all in a downward spiral, that short sellers are providing the liquidity to the market necessary to help these corporations’ share prices level off.

Banning short selling of these stocks has mostly caused backlash from the markets as it is seen as too overt of government interference in the market.  It is worth noting that the United Kingdom’s financial regulator, the U.S.’s SEC counterpart, the Financial Services authority (FSA), has also introduced a similar ban on short selling.  It was also acknowledge by Chancellor Alistair Darling of the U.K. that short selling does indeed provide needed liquidity in periods of decline, but that it was harmful in their current situation.  This rhetoric sounds oddly familiar.