Short selling is a practice whereby an investor borrows securities to immediately sell them to a third party, with the intention to buy it back, at a later point in time once the price has decreased. The difference between the higher price at which the security is initially sold and the lower price at which it is repurchased and returned to the lender, minus the fees paid to the borrower, represents the profit of the short seller.
Covered vs Naked Short Selling
- Covered short selling involves borrowing securities or having an intention to borrow securities via a locate before making a sale.
- Naked short selling occurs when the investor has not borrowed securities or shown an intention to borrow securities prior to the execution of the short sale. Naked or uncovered short selling is banned in most jurisdictions globally.
- Covered short selling is a legitimate and widely used trading technique that plays a crucial role in maintaining market efficiency, facilitating better price discovery and underpinning market liquidity. To enable short selling to fulfil its pivotal role within the capital markets ecosystem it relies heavily on the availability of securities from securities lending programmes to allow market participants, to execute short sales and implement effective hedging strategies.
Short selling can correct market inefficiencies and act as a stabilising mechanism by bringing over-inflated stock prices back to their true market value, through allowing investors to express sentiment against overvalued stocks.
Some view short selling as a questionable practice, as they consider it as profiting from a company’s decline in value. However, most economists now recognise it as an important part of a well-functioning market because of its ability to bring over- or under-inflated stock prices back to their true market value.
To avoid the abuse of short selling, it is crucial that it is conducted within a regulatory framework to ensure market integrity. In March 2012, the European Commission published EU Regulation 236/2012 (commonly known as the EU Short Selling Regulation). This regulation sets out rules for short selling and certain aspects of credit default swaps within the EU. It aims to promote transparency and consistency in short selling practices.
In the US, the SEC implemented rule 13f-2 which also requires disclosure of short positions exceeding a specific threshold by certain institutional investment managers.
Find out more about Short Selling Regulation (SSR) here.
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