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. Investing

    What a Fed Delay Means for the ECB & BoJ

    The Fed’s continued delay has repercussions for more than just the U.S. economy and markets. The ECB and the BoJ may support the case for stocks in Europe.
  2. Term

    Understanding Short Covering

    Short covering is buying back borrowed securities to close an open short position.
  3. Professionals

    Top Stocks to Short, Go Long On to Beat the Market

    A long/short portfolio can help weather a variety of market scenarios. Here's how to put one together.
  4. Mutual Funds & ETFs

    Using Short ETFs to Battle a Down Market

    Instead of selling your stocks to get gains, consider a short selling strategy, specifically one that uses short ETFs that help manage the risk.
  5. Investing

    Watch Your Duration When Rates Rise

    While recent market volatility is leading investors to look for the nearest exit, here are some suggestions for bond exposure in attractive sectors.
  6. Investing

    A Quick Explanation of How Short Selling Works

    Explanations of short selling can be hard to grasp. Here is a quick, realistic example.
  7. Chart Advisor

    Downtrending Stocks to Short or Sell

    These stocks are trending lower and currently near a short sale areas, based on breaks lower and falling stock indexes.
  8. Chart Advisor

    Second Chance Entries Into Completed Double Tops

    These stocks have already completed double top chart patterns, and are right now offering a second chance to trade it.
  9. Forex Strategies

    This Might Be the Best Time to Buy Colombian Pesos

    Signs are growing that energy markets are bottoming out, allowing the Colombian Peso to recover its value in a profitable trend against the U.S. Dollar.
  10. Active Trading Fundamentals

    Short Selling Tutorial

    Short selling makes it possible to sell what one does not own, by borrowing an asset, selling it, and then buying it back to replace the borrowed asset.
  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. 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 >>
  6. 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 >>

You May Also Like

Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!