Short Selling what is it and why the impact on the market today?

The markets fell sharply this morning following the German Government’s decision to ban the short selling of certain govt stocks and financial institution’s shares until March 2011.

But what is Short Selling?

Certain traders on the markets borrow stocks from lenders and then sell them, expecting the price to fall. They then buy the stock back at the lower price and return the stock to the lender, keeping the difference in price.

Example

Trader A borrows ABC stock valued at £1. It sells it to Trader B at this price.

The price of the stock falls to 50p.

Trader A then buys the stock back at the lower price making a handsome profit as it returns the stock to the lender.

In particular there is a way of trading called “naked” short selling, which the German Government is looking to ban.

This is the same as above but where Trader A, in my example, sells the stock to Trader B before even borrowing it from the Lender.

The impact of this form of trading is believed to be causing unnecessary fears about the stability of certain stocks or bonds. Many believe it is playing a role in the volatility of Portuguese and Greek govt bonds.

So why did this impact on the markets?

The markets have panicked amid concerns about other nations following suit and the possible impact this may have on the bond and equity markets as a whole. A major issue here is the fact that Germany, as a Euro zone country, has yet again acted independently of other Euro zone nations potentially impacting on all of them.

This causes significant concerns about the stability of the Euro.

Many governments are currently reviewing the concept of Short Selling. Personally the sooner it is banned permanently the better!