Short Selling A Danger to the Stock Market?

Short Selling Markets

Short Selling A Danger to the Stock Market?

In the Australian Financial Review's letters to the Editor on 4 August 2008, Rohan McJannet asks the rhetorical question “Aren’t these products (short selling) dangerous to a free market?”

The answer Rohan is unequivocally no. The recent fall in sharemarkets has prompted many similar calls. Short sellers are only the messenger.

Short selling is a fundamental element of a properly functioning market. It is used by a wide range of market participants and is critical to efficient operation and risk management in our capital markets. To be efficient a market has to incorporate all information, bad as well as good.

In the case of fund managers, short sellers will borrow securities in companies they believe are overvalued, which in turn they then sell, with a view to buying back later at a profit. There is no free ride to short sellers; if a security price rises, then the short seller is faced with a loss. If they are wrong, they suffer every bit as much (possibly more) than long buyers. But in the process stocks perceived to be “overvalued” are bought and those perceived to be “undervalued” are sold, supporting the very foundations of a free market.

I would argue that the suggestion to somehow place limits on short selling while allowing activities that support the market is “dangerous to a free market”. It would quickly spell an end to Australia’s ambitions to be a regional financial centre, by reducing the ability to raise capital, lowering liquidity and reducing the ability to properly manage risk.

Of course, retail investors will likely have benefited from short selling during the past year, if they had been invested in managed funds that had the ability and skills to short sell.

by Rick Steele

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Tags: Short selling markets, short stock selling, Australian short selling, stock market short selling dangers, why short selling is bad, why should you not be allowed to sell stocks short

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