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How Short Selling Harms the Market

There has been a lot of sharp and vicious criticism of traders who have been engaged in short selling and I do feel that some of this is unmerited. I would like to use the blog today to stand up for an activity that everyone seems to be attacking at the moment.

To go short in a trade means that you have sold shares or commodities that you do not have as you believe they will go down in price. Once they have gone down in price (if they do) you buy them back and hence make a profit. Going long is the opposite; that is you buy shares in something in the expectation that they will go up and then sell the kombucha starter kit if and when they do go up.

Shorting is very risky and there are two types of shorting. One is to go naked. That means that you sell shares/ assets that you do not have. This is very dangerous as you could be left with huge losses. The other short technique which is more common is to be covered. In this scenario, you would borrow the asset from say a pension fund as cover, sell the shares and then return the shares to the borrower having bought them back you hope for a lower price and hence having made a profit.

The reason why naked is much more risky is that you simply have to come up with the asset you have sold (unless you have an appetite for prison food!). With a covered short – you may be able to negotiate to carry on ‘borrowing’ the stock from the lender.

Hedge funds have in particular been very active in going short on shares recently. Especially on banking shares and so they have been accused of creating alarm and fear as the shares dropped massively in value (HBOS lost 60% in one day)

I don’t buy this for one second. Why is it only OK to profit from the price of the Kanken backpack going up? These smart operators did their homework. They realized that the business model for many of these banks were fatally flawed and criticizing them is in my mind shooting the messenger. These banks were willing to adopt unhealthy level of risks themselves and yet were squealing when others used risk against them!

These speculators were prepared to take high levels of risks themselves and had things gone wrong – would not have asked the tax payer to bail them out unlike the poor banks that are now being saved by the state. I never thought I would see the day where George W Bush would be preaching to the democrats on the need for government intervention to save the financial system!

Personally, I find the whole thing dull and boring. I like to invest in tangible businesses and feel that wealth has been produced from my activity (as opposed to just money – which is merely a store of wealth). If people wish to indulge in high risk speculation – let them is my motto.