Tuesday, May 11, 2010

Why short selling is important?

The other day with markets plunging 1000 points, many voices are raised to stop short selling once more. Long term investors were the loudest in the bunch, and from their perspective that maybe make sense. Unfortunately there is always other side of the story. Yesterday market bounced and nobody asked how much of that bounce is because of bears closing their short positions. I would guess a lot. So as short sellers are pushing market down they are pushing it up as well when they are squeezed and running for cover.

Short selling, in principle, offers a number of advantages to market participants and the wider economy. These include faster price discovery in the market, greater liquidity, and enhanced opportunities in risk management. All these effects are considered to add to the efficiency of financial markets.

In principle there is nothing wrong with short selling. Short selling can provide markets with important information on pricing, facilitate the management and hedging of risks in many firms around the world, and provide financial markets with liquidity. In other words, short selling promotes the efficiency of functioning markets.

Selling an asset that you do not own certainly sounds counterintuitive, but it needs to be kept in mind that the asset needs to be re-purchased at some point – any short seller becomes a buyer. Also, for any short seller there is a buyer who expects prices to rise. And there is a lender who calls his shares when their value declines too rapidly.

Short selling can be used by market abusers just like any other financial instrument, and that is where strict regulations must come in.

I hope I shaded some light on the current topic for better understanding of short selling.

Trade with trend!


freeman said...

Excellent post ALSI_TRADER. Short selling is another avenue of trading that I feel is under utilized. It provides an excellent opportunity to maximize returns on both sides of the market and also allows for hedging of long term positions. It is a tool that should be used by traders and long term investors alike.

I love your articles, keep them coming.

Anonymous said...

Also look at markets where short selling isn't allowed. When all the long term investors run for the door at the same time there is no short sellers who would like to buy back their positions, thus, no buyers, only sellers = market plunge!

Alsi Trader said...

Thank you freeman.

Will try to keep them coming.

Alsi Trader said...

Thank you Anonymous.

With you 100% on this.