Ethics And Role Of Short Selling

Ethics of short sellingMostly investors considers the short selling as UN-American and chance against the home team because these sellers are perceived to seek out troubled companies. Some of the critics also believe that short sales are a major cause of market downturns. But despite all critics it is difficult to deny that short selling makes an important contribution to the market by;

  • Adding a liquidity to share the transactions. The additional buying and selling reduces the difference between the price at which shares can be bought and sold.
  • Driving down overpriced securities by lowering the cost to execute a trade.
  • Increasing the overall efficiency of the markets by quickening price adjustments.

However the short selling also has a dark side courtesy of a small number of traders using unethical strategies to make a profit. And sometimes it is also called as the shorts and distorts and this technique takes place when traders manipulate stock prices in a bear market by taking short positions.  Short selling is a little understood and much derogated technique by which traders can profit from their belief that a company’s stock is overvalued.  Short selling has become under fire for the last two years because of the financial problems and then with new regulations proposed to restrain the practice. Critics say that it is unpatriotic, disastrous and damaging. On the other side the defenders say that short sellers add liquidity to the markets. When short sellers are present then buyers experience a more liquid market because they face a larger pool of sellers. More sellers and more liquidity means that more predictable prices and smoother price changes.

The mechanics of short selling are simple. Sellers borrow the stock and sell it by hoping that its market price will decline so homeowners can repay their loan with stock that they buy cheaply. The short sellers should pay the lender the amount of any dividends that the stock pays while he is short. And most of the brokers require cash on deposit to cover the obligation to buy the stock later on.

Limitations and risks of the short selling: –

Short selling is not an investment option for the faint hearted.  The risks of short selling are very high and there is a possibility that the investor could lose largely with a short sale. A short seller speculates that the price of a stock will decline. In the result the short seller hopes that the business or company will fail in the near future. Sometimes short sellers are not beyond spreading the negative rumors about a company whose shares they have shorted on to push the price down.

Limitations of short selling: –

  • Round lot trading: – Short sellers can only trade in round lots of shares which mean that only blocks of 100 shares can be sold short in the market.
  • Types of securities: – Those securities that trade at a low price typically below $5 or are not listed on major stock exchanges cannot be short sold. Such stocks are often classified as penny stocks. They are considered highly theoretical and investing in them is very risky.
  • SHO regulation against naked shorting: – The SEC brought this regulation to ensure that short sellers could actually fulfill the delivery requirement for the stocks they have shorted. A short seller is required under this regulation to provide enough evidence that he can get possession of the securities he has to repay. This prevents speculators like day traders from making massive short sale transactions with zero initial investment and without having the necessary funds or access to buy back securities if it becomes necessary.

Risks of short selling: –

Short selling is a risky affair and it is difficult to deny that how many regulations and limitations are imposed by the SEC to safeguard the markets. Here is a brief look at some of the risks involved in short selling;

  • There is no ceiling on how much a short seller can lose in a trade. The share price may keep going up and the short seller will have to pay whatever the prevailing stock price is to buy back the shares
  • A short seller has to undertake to pay the earnings on the borrowed securities as long as he chooses to keep his short position open. If the company declares huge dividends or issues bonus shares, the short seller will have to pay that amount to the lender. Any such occurrence can skew the entire short investment and make it unprofitable.
  • The broker can use the funds in the short seller’s margin account to buy back his loaned shares or issue a call away to get the short seller to return the borrowed securities. If the broker makes this call when the stock price is much higher than the price at the time of the short sale, then the investor can end up making huge losses.