Don't know what short-selling means? Haven't got a clue how it caused HBOS to collapse? Donna Werbner can help!
A lot of fuss has been made recently about short-selling. It’s been blamed for the collapse of HBOS, banned by the FSA on financial company shares and generally labelled as ‘evil’ by the media everywhere.
But what is short-selling – and how did it contribute to the current banking crisis?
What is short-selling?
Short-selling – or “shorting”, as it’s often called – is selling shares you don’t own. It allows you to make money when the share prices fall.
Hold on a minute! How can you make money out of share prices falling? And how can you sell something you don’t own?
Here’s a step by step guide to how shorting works:
1. You borrow some shares for a set amount of time and pay a small fee to person who owns them. You agree to return those shares at a later date.
So there you are, with a load of borrowed shares you don’t own, which you’ve paid a fee for. Doesn’t sound great, does it? How can you make money out of this situation?
2. You sell the borrowed shares on to someone else.
3. Later you have to return the shares to the original owner - except you've already sold them. So you have to go back into the market and buy them.
4. If the share price has fallen, you're quids in. This is because you can buy the shares back for a lower price than you sold them for.
A Worked-Out Example
Confused? Here’s a worked-out example, which will hopefully clear things up:
I borrow some shares from Ed, my boss, that are worth £100 for a small fee of, say, a £1. I promise to return these shares in a month.
I then go off and sell the borrowed shares to my Foolish friend and colleague, Jane B, for £100. That’s £100, in my bank account.
A month later, I have to give the shares back to Ed. Luckily, the price of the shares has fallen by 20% during the month. So I take £80 out of my bank account, and buy the shares back. Then I return the shares to Ed, the person I borrowed them from, and pay Ed £1. But I get to keep the £20 in my bank account that I have made in the intervening period!
Of course, I am taking a risk. If the price of the shares had gone up that month, instead of down, I would have lost money. This is because I would be forced to buy the shares for more than the price I sold them for. Instead of pocketing the difference, I would be forced to cough up.
Did short-selling cause the banking crisis?
I don’t think it caused it – what happened was too big to have one single cause - but I do think it probably contributed to the downfall of both Lehman Brothers and HBOS.
Many investors chose to short stocks in these companies because they legitimately had concerns that they were carrying toxic mortgage debts, and therefore the share price would fall.
But the more that investors short stocks, the more likely it is that the price will fall. This is because lots of people are trying to sell the shares, and few are wanting to buy. And as in any other situation where there is low demand, prices fall.
When prices fall, confidence in the company also falls, and more and more investors want to sell.
So the more people shorted stocks, the more the price fell, the more people shorted stocks, the more the price fell, the more people shorted stocks… and so on and so on.
To stop this never-ending downward spiral from continuing, the FSA has now stepped in and banned investors from shorting financial stocks until January.
This means that, while the share price of financial companies may still fall, it is much harder for investors to make any money from share prices falling.
Hopefully this will create more stability in the financial markets… but only time will tell. So much has happened in the past week, I’m certainly not betting things will get back to normal any time soon.
But then again, if I’d been a betting kind of gal, I wouldn’t be writing this. I’d have shorted HBOS stocks on Monday when they were priced above £2, bought them back Wednesday morning when they were priced above £1, and today… well, naturally, I’d be off enjoying my millions on a Caribbean island somewhere…
PS. Private investors can short shares without going through all the rigmarole of borrowing, selling and buying. They can spread bet. I'd need another article to explain that. I'll just say that it's a high risk way of gaining from falling share prices. It's high risk but some spread betters make money.
> If you think share prices are going to go up, invest in an index tracker, a cheap and simple way to invest in the stock market.
