In its simplest form, short selling involves taking a speculative position that a stock's price will fall; essentially it is the opposite of buying, or going long. Short selling, or shorting, also has psychological implications for the market whereby an elevated number of short positions introduces a negative market sentiment, thus driving down equity prices. Regulators can therefore attempt to curb these bearish forces before they spiral out of control. Such action was taken at the onset of the Great Recession, four days after collapse of Lehman Brothers. Similar measures are now being implemented in Europe, amidst the European debt crisis. (The media demonizes naked short selling, but in most cases it occurs in a collapse rather than causing it. Check out The Truth About Naked Short Selling.)

TUTORIAL: How To Use Short Selling

2008 and 2011
In 2008, the Securities and Exchange Commission (SEC) "took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence." These measures were taken to prevent bearish speculators from gaining full control of the market, thus forcing unprecedented pullbacks in prices. Following the recent turmoil in Europe (and the Middle East and the United States and Africa) regulators in France, Belgium, Spain and Italy declared a 15-day ban on shorting banks and insurance companies. While not all members of the European Union support this new regulation, similar evidence of market abuse prevention is cited as the cause for the ban.

European Selloff
Politicians in Paris maintain their position that French debt is undoubtedly worthy of the AAA credit rating; Italian Prime Minister Silvio Berlusconi has upheld a similar belief, stating that the economic and financial position of Italy are "solid" and "investors' evaluations of our bonds don't take into proper account the solidity of our banking system." Investors, however, are ignoring these reassurances and have proceeded to sell their positions in Italian and French financial institutions. Prior to the ban on short selling, the iShares MSCI Europe Financials ETF lost nearly 30% of its value within the last few weeks, largely driven by short term speculative activity.

Temporary Protection
Shortly following the short selling ban, major French Banks BNP Paribas and Societe Generale spiked by 4.2% and 2.1% respectively while Italy's UniCredit jumped by over 5.5 percent, halting a steady downward trend. Unfortunately for France, Italy and other debt burdened European nations, short selling is a natural component of the financial markets that provides liquidity and a form of check-and balances to prevent prolonged periods of unstable hyper growth. After the 15-day period expires, the fundamental and psychological forces which normally drive the market will once again reemerge. After the 2008 ban on shorting, the Dow Jones Industrial Average continued to lose value until finally hitting its low on March 6, 2009.

Bottom Line
Although the initial response to the ban has been positive, a robust long-term action plan must be implemented in order to ensure that the debt problem will be properly managed. Ideally, this 15 day period will provide politicians more time so that they can figure out an alternative, whether it be comprehensive austerity or moderate budget reorganization before normal market activity is resumed. Enforcing a ban on short-selling does not remove the inherent risk present in Europe's financial sector. (This controversial strategy is blamed for making and breaking markets. Read Questioning The Virtue Of A Short Sale.)

Related Articles
  1. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Investing

    How to Spot Secular Bull Markets vs. Secular Bear Markets

    A guide to identifying secular bull and bear markets.
  4. Economics

    Who Stands To Lose (And Gain) From The Paris Attacks

    For every major world event, there are those who stand to lose and those who stand to gain. A look at the short, medium, and long-term impacts of the Paris attacks.
  5. Investing News

    How the Paris Attacks Could Impact the Economy

    The horrific terror attacks in Paris will have a ripple effect on comsumer spending and tourism.
  6. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  7. Mutual Funds & ETFs

    Benchmark Your Returns With Indexes

    If your portfolio is always falling short, you may not be making an apples-to-apples comparison.
  8. Investing News

    Defensive Investing: Learn from a Hedge Fund Pro

    Looking for ideas on companies, sectors or investments to short? Consider the opinion of this hedge fund luminary.
  9. Trading Strategies

    Finding Momentum Plays in Flat Markets

    Momentum traders should reduce frequency and size in flat markets, while seeking out story stocks that continue to trend higher or lower.
  10. Professionals

    Common Interview Questions for Project Managers

    Discover the basic skills needed for a position as a project manager along with common interview questions used in applying for such a position.
  1. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
  2. How can an investor profit from a decline in the real estate sector?

    Speculation enables investors to profit from a decline in the real estate sector. The most popular forms of speculation for ... Read Full Answer >>
  3. In what ways does Bayesian probability support the probability default model when ...

    During the European debt crisis, several countries in the Eurozone were faced with high structural deficits, a slowing economy ... Read Full Answer >>
  4. How can I evaluate if a stock is a short squeeze?

    To evaluate whether a stock is a short squeeze, traders should examine its fundamentals, short interest and price history. ... Read Full Answer >>
  5. How does days to cover a short position relate to a short squeeze?

    Days to cover a short position reveals the intensity and duration of a potential short squeeze. A short squeeze occurs when ... Read Full Answer >>
  6. What is the difference between a short squeeze and short covering?

    "Short covering" and "short squeeze" are different terms to describe a situation involving short positions. A short squeeze ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center