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.
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.
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.
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.)