60 second guide to short sellingEurope blocks risky bets on banks amid turmoil

13 August 2011

Stock markets graph

Markets have risen on the news of the short selling ban in some parts of Europe

Four major European countries have banned investors from making risky bets, known as 'short selling' on the shares of its banks in a bid to calm the volatility of the market and protect its financial institutions. 

The 15-day ban comes amid major falls in stock markets around the world over the past week and concerns about the health of the European banking industry in the new financial crisis.

The move has seemingly calmed the market, with FTSE 100, Cac, Dax and Dow Jones stock markets all rising on the news. This will bring some relief to investors, whose share investments have taken a battering in a period that saw the FTSE 100 slide by 11% in as many days.

With this in mind, Which? Money guides you through the complexities of short selling and how it affects the markets. 

What is short selling?

Traditional investors buy shares, bonds or other financial ‘securities’ they think are undervalued, and aim to make a profit when their selections rise in value. This is approach is usually called a ‘long’ investment.

Short selling allows traders to to make a profit from falling prices, but it’s very different from the traditional ‘long’ way of investing. If a trader thinks a company’s shares are going to fall in value, they borrow the shares (usually from a large shareholder in the company) and sell them at their current market price. When the share price has dropped, they buy back the the shares at their new, lower price and return them to the lender, thus making a profit for themselves.

Can you give me an example of how this works?

Ok. So, a trader thinks shares in Company X, priced at £3, are overpriced and believes they will fall in value over the next three months. He borrows and sells 10,000 shares in Company X, receiving £30,000. Three months later, the share price has dropped to £2.50. To fulfil his agreement, the manager buys the 10,000 shares he owes the lender for £25,000, making a £5,000 profit (before deducting buying and selling costs).

Why has short selling been banned?

Stock markets and share prices increase and decrease on market sentiment. If investors are negative about about the shares of a company or the markets altogether, this can result in falls. The regulators in Europe believe that short selling, which looks to make a profit from falling prices, exacerbates this negative sentiment, sometimes even by spreading false rumours about the health of companies, and has decided to ban short selling of the shares of financial institutions. 

Why does the short selling ban only apply to financial company shares?

Regulators do not want a repeat of the banking crisis of 2008, which saw investment bank Lehman Brothers go bust, RBS and Lloyds Banking Group nationalised and huge falls in global stock markets. Therefore, they believe that stopping short selling will help ease the volatile share prices of their banks and restore confidence in those that lend to the banks. 

The markets have responded well to this move. The share prices of banks in Europe and Wall Street have risen on the news.

Does banning short selling always work?

Some argue that banning short selling doesn't materially make a difference if a stock market is declining. Others say that, worse still, banning it sends out an even more negative message to the markets, causing them to fall further.

When Lehman Brothers collapsed in 2008, the UK banned short selling on the shares of banks. However, it appears that this did not stem further falls in the FTSE 100.

Learn more about the turmoil of the recent weeks and how it might affect you.

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