A quick guide to short selling

Hannah Green
Working Lunch

The Financial Services Authority (FSA) last night made the surprise decision to temporarily ban the short selling of financial shares. The move came into effect at midnight and is set to remain until January 16, although the Authority will review the judgement next month.

While the practise of selling short is completely legal, it is considered very risky and has come under a lot of scrutiny. It is the process of selling a financial contract like a share or bond which you do not currently own. You do this in the hope of making profit. For example, you could "borrow" a share from person A and sell it to person B for £100. You wait and hope that the price will fall. If it does, say to £50, you can then buy the "borrowed" share back off person B at this lower price. You return it to person A with a small fee as thanks for letting you borrow it and you've made a profit of £50 minus the fee.

So why is it such a problem?

It can be incredibly risky and in many respects it is like gambling on prices falling. Moreover, because the potential financial rewards are often substantial, the incentive to help prices fall are large. This can happen through traders spreading rumours about company performance or through the signal that significant amounts of short selling sends to the market that many believe future price falls are likely. The more people act on this generated speculation, the more it can affect the value of an otherwise healthy investment.

Furthermore, although anyone can short sell, most organisations involved are private investment funds called hedge funds. Such groups have vast amounts of money (combined, their current value is estimated at £1.37 trillion worldwide) which magnifies the problems when things go wrong.

Traders have also been criticised recently for targeting the shares of HBOS and other failing banks to make a quick profit as prices fall.

Is short selling really to blame for the most recent turmoil?

The verdict is still out but most experts believe not. For in order for shares to be shorted, they first need to be borrowed. On Tuesday, when HBOS shares were plunging, only 2.75% of its shares were out on loan compared to 18% in July, according to research firm Data Explorers.

Furthermore the Investment Management Association states the practice of stock lending makes an important contribution to the orderly operation of the market. Short selling can in fact play a key informative role; often exposing the real value of company's shares.

What does the ban hope to achieve?

The FSA and the government hopes the ban will restore confidence in the banking sector. Markets are already responding positively and many in the City support the move. Gordon Brown has claimed this is the beginning of a "clean up" and says he is prepared to take "whatever action is necessary so we have a stable financial system".

Time will tell whether the ban on short selling and other moves are successful. We'll keep you posted...