Page last updated at 10:34 GMT, Monday, 22 September 2008 11:34 UK

Q&A: What exactly is short selling?

The investment practice of short selling has been banned in the UK, for 29 specific financial shares, until 16 January 2009.

Halifax branch
The fall in the HBOS share price may have been partly a result of short-selling

It has been held partly responsible for undermining confidence in the UK's biggest mortgage lender HBOS.

The decision of the Financial Services Authority (FSA) was an attempt to clamp down on some of the extraordinary recent falls in the value of shares in the banking industry.

The experience of HBOS ended with that bank being taken over by Lloyds TSB, but the FSA and the government are clearly worried there may be more examples to come.

So what is short selling?

It is a technique that sees investors borrow an asset, such as shares, currencies or oil contracts, from another investor and then sell that asset in the relevant market hoping the price will fall.

The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference.

The same effect can be achieved without even borrowing the shares at all, but simply by using derivatives contracts - glorified bets.

This practice may have been to blame for the slump in the shares of HBOS after it announced plans to raise 4bn through a rights issue back in April, and contributed to further huge falls in its shares in the three days before its takeover was announced.

Why does short selling reduce share prices?

If lots of traders are short selling a particular share then the first thing they will have to do is borrow the shares.

Once they have done that they will sell them.

What it will mean is that at the current price, more people are trying to sell the share than are trying to buy it and that will push down the share price.

Compare it with a situation on a particular street on which two homes are for sale.

If five more identical houses on the street are suddenly put on the market then it is likely that prices will have to be cut if they are all going to be sold.

The other effect happens because some institutions are known to be specialist short-sellers.

If everyone sees that one of those institutions has sold a load of shares in a particular company, then there is a danger that there will be panic in the market as other shareholders worry that the price could plunge.

Who can short shares?

Anyone can short a position in a company's shares, but typically hedge funds are the main players.

Many of the main investors in hedge funds are pension and insurance funds.

For any party who is going short, there needs to be another party who wants to bet that the shares or commodities will not fall as far as the short seller believes.

Why has it been getting a bad press lately?

Short sellers have been accused of targeting the shares of HBOS and other banks at a time when there were doubts about their ability to raise long-term finance as financial markets have been seizing up.

Are short sellers solely to blame for the slump in HBOS shares?

Many analysts say no.

In order for shares to be shorted they first need to be borrowed, and there are figures available showing how many are on loan at any given time.

On Tuesday 16 September, when HBOS shares were plunging, only 2.75% of its shares were out on loan, according to research firm Data Explorers.

That compares with July - the month shares began trading under its rights issue - when 18% of the shares were out on loan.

Many hedge funds argue that short sellers are often pointing out an uncomfortable truth about the financial position of the companies whose shares they are selling - that they are not as valuable as people think they are.

As such, it is argued, they are often doing everyone a favour by exposing the real value of a company's shares. The financial equivalent of the boy who pointed out that the emperor had no clothes.



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