Is This Really Short Selling?

Jeff Randall explains a short sale:

Put simply: I know that you want to buy 100 shares in Jayar Junk. The shares are trading at £10 each. We strike a deal at that price, and I promise to deliver them in one week\’s time. At this point, I still don\’t own any Jayar Junk. No matter, my buddies at the Rumour Mill are about to go to work.

Through a series of postings on dodgy websites, anonymous emails and loose talk in dealers\’ watering holes, we spread the story that Jayar Junk is running out of readies. Very soon the shares start falling, to £9, £8, £7. In angst-ridden markets, there is no bottom. When they hit £5, we buy 100.

Bingo! You are contracted to take them from me for a total of £1,000. My cost is just £500. I double my money and you are ripped off. It\’s no more complicated than that.

That looks more like a future to me than a short sale.

A short is where you borrow the stock and sell it, then buying it back at the new lower price and return it to the original owner, no?

20 comments on “Is This Really Short Selling?

  1. Yes, I believe you are right. And there is another flaw in the narrative – the putative doubling of the money. Where is the actual investment of £500 capital? You already have a definitive upside – the only risk (apart from being caught, sacked and fined for market manipulation) is that the mark defaults on their side of the contract.

    Even with the credit crunch, I am sure that a short-term loan of £500 can be had at very reasonable rates (even if it cannot just be got within the market accounting mechanism.)

  2. Yeah, you’ve got shorting right and Randall is describing a future and , of course, its perfectly possible to short a future if you’ve a mind to.

    I do hope Randall isn’t one of the Telegraph’s financial journalists because if he’s then he’s making a very good case for buying the FT.

  3. It is not even a future, as there is no cost for setting up the contract, as would normally occur.

    The cost is normally what the seller thinks is the risk they might lose out.

  4. “The cost is normally what the seller thinks is the risk they might lose out.”

    Which isn’t true for lending your stocks in short selling: if you wanted to stay long in a stock your risk is limited to default risk of the borrower.

    Of course, very few of us lend our stocks: our lovely brokers lend them without us even knowing (actually, we do know if we bother to read the small print).

  5. Er, sorry to disagree with the majority here, but what Randell has described is exactly how a short position in the stock market operates. Or at least it worked like that when I took them.
    When you buy or sell shares, you don’t have to take or make delivery of the stock immediately but on a ‘settlement day’ in the future. When I used to do it for a living (back when you could still find dinosaurs browsing the foliage in Finsbury Circus) accounts were a fortnight long & the settlement day 10 days after that. (It’s probably changed somewhat now but when I tried to search for the exact current procedure I got lost in a maze of Forex markets & derivatives.) Anyway, loosely speaking, you could buy on a Monday & as long as you sold the stock before the close of trade the next Friday but one you never had to pay for it. You just were liable for the difference if it went down & reaped the rewards if it had risen. A short position is just the opposite of that. You sell stock you don’t hold and as long as you cover your position by buying it back before you have to deliver it’s just a money transaction.
    Of course the uneducated at this point get all excited about avaricious speculators distorting the market, but it’s speculation that keeps markets stable. For every buyer there has to be a seller so it’s dealers trading against the market trend that usually prevent wild market swings.

  6. Further to the above, if you’re looking for a culprit for all of this blame computerised share trading. Back in the physical market I worked in a rumour like that would have evaporated halfway round the market floor. We actually knew who was doing the trading & you can’t beat the calculator you keep between your ears for spotting patterns. Most likely result would have been some hedge traders licking their wounds by now & a few smug faces booking expensive holidays.

  7. “For every buyer there has to be a seller so it’s dealers trading against the market trend that usually prevent wild market swings.”

    Absolutely, but the emphasis there is on “usually” since speculative shorting can also initiate wild market swings. That’s one of the reasons why the banks are now pressing the Bank of England to relax the terms under which it acts as lender of last resort.

  8. “speculative shorting can also initiate wild market swings.”
    As Ed Balls would say; “So what?”

    With a major bank 99% of the shares are tucked away in pension funds, investment trusts other long term holdings. The traded volume is a tiny percentage of issued capital. If there really is no problem with the bank the swings swiftly dampen & the only ones who get hurt are the speculators.

  9. “If there really is no problem with the bank . . ”

    But there was fundamentally nothing wrong with HBOS yet its shares were down at 20% at one stage – and those shares are the assets of other financial institutions, as you recognise. Even the Northern Wreck is (probably) solvent in the longer run but a calamity can happen between now and the longer run through what this week’s The Economist terms “entanglement”:

    “entanglement is a new doctrine in finance”
    http://www.economist.com/opinion/displaystory.cfm?story_id=10880718

    That is why the FED in America recently acted so swiftly to engine a take-over of Bear Sterns – an investment bank and therefore beyond the normally understood range of lender of last resort support from central banks.

    The rule book of central banking is being rewritten through necessity. I’m not rejecting the notion of a beneficial contribution to financial market efficiency from shorting but then I’m not denying the potential downside either.

    The Milton Friedman view that speculators who act on invalid assumptions eventually lose out and therefore disappear as active players is altogether far too complacent an assessment with globalized financial markets. A whole lot may happen before malicious or ill-informed speculators disappear from the market – which is precisely why the retail banks in Britain are pressing the Bank of England to the relax the stringency of the terms on which it previously provided lender of last resort financing just to the retail banks in Britain. But then I also understand the Bank of England’s (sensible) concerns about stoking financial moral hazards downstream and prompting more imprudent lending by financial institutions.

    The current US prime mortgages fiasco which triggered all this is but an amplifide replay of the previous Savings and Loan Association Crisis of the 1980s and 1990s:

    “The US Savings and Loan crisis of the 1980s and 1990s was the failure of several savings and loan associations in the United States. More than 1,000 savings and loan institutions (S&Ls) failed in ‘the largest and costliest venture in public misfeasance, malfeasance and larceny of all time.’ The ultimate cost of the crisis is estimated to have totaled around USD$160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government, which contributed to the large budget deficits of the early 1990s.”
    http://en.wikipedia.org/wiki/Savings_and_Loan_crisis

    On the evidence, Americans are evidently completely incapable of learning from their own adverse experiences. As a result, we all have to withstand the internationally toxic consequences of their incompetent governance.

    America is a demonstrably failed state. When do we invade to save America?

  10. No Tim, what you’re describing is called “naked short selling” and is being used to manipulate the share prices of companies to such an extent that they go out of business and the “naked shorter” makes a fortune.

  11. “But there was fundamentally nothing wrong with HBOS”

    You could make the same argument about Bear Stearns. Once a run begins, it can take the bank down, regardless of its health. And of course in those cases, the ones joining the rush for the exit are justified in doing so.

  12. “Americans are evidently completely incapable of learning from their own adverse experiences”

    Those living in glass houses with negative equity shouldn’t throw stones. My young neighbour was visibly shocked to hear my story of a friend in the mid 1990s who had negative equity of £20k and took several years to pay it off in order to move house. The whole concept had never even occurred to her, and yet she is also a buy-to-let landlord.

    There’s a whole generation who have grown up and bought houses who never experienced the last property crash. For them, housing has been a one-way bet, and only now is it starting to sink in that there is no such thing.

  13. “But there was fundamentally nothing wrong with HBOS yet its shares were down at 20% at one stage – and those shares are the assets of other financial institutions, as you recognise.”

    So again, where’s the problem? The institutions are holding the stock as a long term investment. They’ve not traded a share. The volatile movement of the share price itself gives a clue as to the tiny number of shares being traded. If large numbers of trades were occurring then you’d have more of a ‘perfect’ market operating, more traders taking disparate views, which would serve to stabilise the price.

    “the retail banks in Britain are pressing the Bank of England to the relax the stringency of the terms on which it previously provided lender of last resort financing”

    Oh boy! If this is going to happen it’s time I gave up on my pledge to never touch another share again & fill my boots. I’m not entirely confident to trust my judgement against the wiles of City traders but if all I’ve got to out think is Government appointed suits let me at it.

    At the moment I’m racking my brains trying to recall an instance of market turmoil that wasn’t connected to a belief that the laws of supply & demand had miraculously been suspended. I’ve started with the South Sea Bubble & I’m working up. No joy yet

  14. “The institutions are holding the stock as a long term investment.”

    Not necessarily so. From what I read, much of the money put in hedge funds and derivatives nowadays is money at call or short notice from other financial institutions.

    If the prices of the underlying assets of hedge funds dip because of malicious or ill-informed speculation (? by shorting) and creditors of hedge funds get rationally panicked into recalling deposits back then there’s a lot that could unravel on an international scale. That’s the basis of current concerns about “entanglement” which I mentioned above.

    “I’m not entirely confident to trust my judgement against the wiles of City traders but if all I’ve got to out think is Government appointed suits let me at it.”

    C’mon. It was Walter Bagehot – when editor of The Economist – who first described (in: Lombard Street) the need for central banks to lend without stint to retail banks in times of crisis – albeit at a penal to inhibit moral hazards – so as to pre-empt systemic failures (= domino bank runs).
    http://www.econlib.org/Library/Bagehot/bagLom.html

    That became a fundamental part of the mainstream, conventional wisdom of central banking.

    Why do you suppose the FED in America – under the chairmanship of Ben Bernanke, an ex-academic economist of distinction from Princeton, appointment by the Bush administration and endorsed by the Senate on a voice vote – acted so promptly to rewrite the rule book of central banking and engine the bail-out of Bear Stearns, an investment bank?

  15. Old “short-trader” proverb:

    He who sells what isn’t his’n
    Must buy it back or go to prison.

  16. “Why do you suppose the FED in America”

    Why all the RANDOM use of upper CASE when talking ABOUT the Federal Reserve System?

    Not picking on you Bob, there are plenty of other in the MSM doing it too.

  17. PJ, it is surely not short selling, as in this case one is agreeing the price in advance.

    Short selling is selling at one price, injecting a rumour is optional, then buying at another – you are square at settlement.

  18. Kay – You are right to admonish me.

    FED – or Fed – is an American shorthand for the US Federal Reserve Bank, the US central bank which was founded in 1913 and is therefore relatively young compared with the Bank of England, which goes back to 1694. Even The Economist uses the shorthand Fed, I discovered on reading this:
    http://www.economist.com/finance/displaystory.cfm?story_id=10881318

    And btw reading that and the whole: Briefing on: Wall Street’s Crisis, is virtually manadatory for anyone who really wants to understand how and why we got to where are. The Economist has kindly posted the Briefing with unrestricted access. The facts are staggering:

    “The seeds of today’s disaster were sown in the 1980s, when financial services began a pattern of growth that may only now have come to an end. In a recent study Martin Barnes of BCA Research, a Canadian economic-research firm, traces the rise of the American financial-services industry’s share of total corporate profits, from 10% in the early 1980s to 40% at its peak last year (see chart 1). Its share of stockmarket value grew from 6% to 19%. These proportions look all the more striking—even unsustainable—when you note that financial services account for only 15% of corporate America’s gross value added and a mere 5% of private-sector jobs.”

  19. And a good reason to worry about the credit crunch in Britain as the banks seek to cut balance sheet risks:

    “The banks’ increasing concern about the risks of the implosion of Britain’s £1.4 trillion debt mountain has led to a huge surge in the number of court orders moving unsecured debt on to a basis that secures it against a borrower’s home.

    “Figures from the Courts Service indicate that the use of charging orders by British banks surged by 580 per cent from 2000 to 2006, the most recent year for which figures are available. Industry sources say that the banks’ increasing use of the tactic to safeguard loans that they view as risky has accelerated since the credit crunch began last summer.”
    http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article3599523.ece

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