Stock Exchanges Curtail Short Selling

Yesterday the SEC and UK’s Financial Services Authority made very drastic moves by disallowing traders from shorting financial stocks.  Selling short is the practice of selling shares of securities that are not owned by the seller.  Shares are borrowed on margin, sold, and then purchased at a later date.  If the price is lower when the shares are repurchased, then the short seller makes a profit.  If the price is higher, the short seller suffers a loss.  I think that banning short selling on financial stocks is a really bad idea for two reasons:

  1. It will undoubtedly cause a short squeeze (as we began to see yesterday with the Dow rising 400 points). A short squeeze takes place when there is a lot of open short interest (a lot of people shorting a stock) and the stock begins to rise.  As the stock rises, many short sellers buy back the stock to prevent or cap their losses.  With many short sellers buying back the stock, it increases the demand for the stock and a snowball effect takes place as the stock skyrockets.  Many short sellers will receive margin calls and will either have to increase the value of the assets in their account or be forced to buy back short positions at a loss.
  2. It does absolutely nothing to solve the problems that are causing financial stocks to drop in the first place. Financial firms have seen their market value falling because of the difficulty they are facing in finding sources of capital.  The cost of borrowing for lenders and banks has increased due to the credit crunch.  Banning short selling on financial stocks does absolutely nothing to resolve the fundamental issues that have caused the market value of financial firms to fall.

The action taken by the U.S. and U.K. regulatory agencies are likely to cause more problems than they will solve.  It will only increase the volatility in the stock market as a short squeeze takes place and after the ban is lifted.  After the ban is lifted, we will likely see the financial stocks drop once again.  Why?  Because the underlying issues still exist and the market will value the price of those financial institutions accordingly.  The day traders are going to really have a field day as they buy up shares of financial stocks and subsequently short them after the ban is lifted.

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