Short Selling

The first rule of investing: buy low and sell high. If you haven't actually bought anything, get someone to lend it to you first, then sell it high and buy it back once the price has dropped. That's the first rule of short-selling — sell high, buy back low, and pocket the difference — and it's a trick that has been hastening market crashes for at least 400 years.

Short sellers see an overvalued stock that they assume will drop in price, so they borrow some shares from a brokerage firm and sell them immediately, at the still-inflated price. If the price drops, they buy back the shares and return them to the lender. If the price rises, the seller still buys them and ends up taking a loss. It's basically old fashioned trading, except in reverse. And because short sellers profit when the price falls, they are often blamed for driving a stock down. On Sept. 19, following one of the most turbulent weeks in stock markets' history, the Securities and Exchange Commission (SEC) banned short sales of 799 financial companies for just that reason. But defenders of short-selling say the practice doesn't cause a market to crash, it merely accelerates the fall. It's a little bit like ripping off a Band-Aid: you can do it the slow way or the fast way, but there's still going to be an injury underneath.

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While regular trading fills the market with people who only want their stocks to go up — and will do anything to ensure that it happens — short selling creates people who want the market to go down, and therefore (its defenders say) does a better job at keeping the market honest. Short sellers were the first to discover problems at Enron, WorldCom and Bear Stearns. As Vanderbilt University economics professor Peter Rousseau puts it, "It's always good to have people on both sides." Critics, however, say that when short sellers pile into a particular stock, their borrowed 'sell' orders can swamp the market — forcing the price to plummet.

Shorts are most visible when any kind of speculative bubble starts to burst. They existed in the Netherlands in 1637, when the escalating price of tulip bulbs suddenly plummeted. (The Dutch, in fact, were the first to ban shorting, back in 1610, when they decided it probably wasn't a good idea to sell something you didn't own). They were around in 1773, when England realized that its South Sea Company had falsely inflated its own stock price. And they were there 1929, when they helped give Wall Street and America a great big wake-up call. More recently, short selling has been blamed for helping precipitate the Asian financial crisis of the late 1990s; billionaire financier George Soros famously netted more than $1 billion by shorting the British pound in 1992.

There's also something called naked short selling, which is a short sale that occurs before the seller has actually borrowed the stock. If the seller can't borrow the shares in time, it's called a "failure to deliver" — a practice that has been illegal since the SEC was founded in 1934, although investors have long found a way around the ban. Some failures are accidents; a computer glitch here, an unexpected difficulty there. But many are done on purpose, when the seller has no intention of following through with the deal. This does reduce a stock's price — all these people are selling, but no one is buying because there's not actually anything to buy — and has been illegal since the SEC was founded in 1934, although investors have long been able to find ways around the ban. If short selling is the sale of something you don't own, naked short selling is the sale of something that may not even exist. Victims of naked shorting can see thousands of phantom stocks trade hands every day, and there's not much they can do about it.

Every time a market crashes, short selling is blamed because even legitimate short transactions — with stocks that actually exist — drive prices down faster. The London Stock Exchange banned short sales in 1787 to protect banking stocks after a large bank collapsed. After the 1929 crash, President Hoover publicly railed against short selling. New York State Attorney General Andrew Cuomo did the same thing last week, calling short sellers "looters after a hurricane." Then came the SEC's Sept. 19 ban, which pushed the Dow Jones Industrial Average up 370 points, even as market analysts called the move little but an ineffective and ill-advised band-aid. As short sellers would argue, they were merely pricking a bubble that was going to burst anyway.