Working, Dynamics and Opinions|
FIM – Spring 2011
Authored by: Muhammad Fahad Raza & Muneeb Shahid
Working, Dynamics and Opinions
What is Short Selling?2
Factors Influencing the Short Selling Process3
Advantages of Short Selling4
Disadvantages of Short Selling4
Short Selling in US5
Short Selling in Pakistan (ISE)6
What is Short Selling?
Short selling is a trade activity in which a short seller typically borrows through a broker, who is usually holding the securities for another investor (owner of the securities); and then on the basis of his estimates or speculations, sells the securities in the market-hoping for the price to fall. The trader eventually buys the stock back, making money if the price fell in the meantime and losing money if prices rose and the lender charges a borrowing fee on the borrowed stocks from the short seller. In many markets short selling is heavily regulated. History
Some theories hold that the practice was invented in 1609 by Dutch trader Isaac Le Maire, a big shareholder of the Vereenigde Oostindische Compagnie (VOC). In 1602, he invested about 85,000 guilders in the VOC. By 1609, the VOC still was not paying dividend, and Le Maire’s ships on the Baltic routes were under constant threats of attack by English ships due to trading conflicts between the British and the VOC. Le Maire decided to sell his shares and sold even more than he had; this was the first documented case of short selling. Working
Factors Influencing the Short Selling Process
Some factors, which effect the initiation and execution of short selling, are discussed below: Pure Intuition
This means that the short seller has adequate knowledge about the stock market and its behavior in recent past. He is then able to speculate the trends the market is going to follow in near future. If the short seller is observing a bullish trend in the market for some time, he would speculate that the market; in an attempt to gain equilibrium, would follow a bearish trend in the upcoming days. On the basis of this intuition, he borrows stock from a broker, sells it at the higher price (on the days the market is following the bullish trend) and buys the same stock back the next day when prices have fallen. The difference in the selling and re-purchase price is the profit made by the short-seller. Market Correction
In general a stock market correction is a drop in stock price, usually after a rapid and/or prolonged rise. Typically a decline of as little as five percent and a much as twenty percent in the Dow Jones Industrial Average is the benchmark for a stock market correction. The decline in stock prices happens over a brief period. When stocks decline over a long period it is referred to as a bear market. Unlike bear markets stock market corrections are secondary market trends. A stock market correction is a market reversal superimposed on a steadily rising bull market. Market correction is a good time for short sellers to execute short trade as stock prices are on the decline; towards their actual value. Inside Information
Persons having inside information about a certain stock can always short-sell based on the confidential information they have access to. Since no other market participants have knowledge about that information, the short seller who trades on the basis of inside information almost always ends up as the winner. Short selling based on inside information is a punishable crime all over the globe.
Advantages of Short Selling
Following are the advantages of short selling
* It is a great way to hedge a portfolio. Many investors can successfully use short positions to hedge their long positions. * Gives you the ability to profit in a down market. Without short selling it can be difficult to profit in a very bearish market. * It...