Long Selling vs Short Selling: How Each Practice is Misused
6 min read
[ez-toc]
Short Selling:
-
Short selling refers to the practice of borrowing shares of a stock and immediately selling them with the hope of buying them back at a lower price in the future and profiting from the difference.
- In short selling, the investor is betting that the stock price will decrease, and they will be able to purchase the shares they borrowed at a lower price than they sold them for.
-
The critical underlying concept of short selling is that the investor is borrowing shares, and therefore, is required to pay interest on the borrowed shares. Additionally, the investor is exposed to potentially unlimited losses if the stock price increases instead of decreasing.
Examples:
-
An investor shorts 100 shares of XYZ stock at $50 per share. The next day, the stock price rises to $60, and the investor must buy the shares back to return them to the lender. The investor has lost $1000 ($60 x 100 – $50 x 100).
-
An investor shorts 200 shares of ABC stock at $40 per share. The next day, the stock price drops to $30, and the investor buys the shares back to return them to the lender. The investor has made $800 ($40 x 200 – $30 x 200).
Long Selling:
- Long selling refers to the practice of purchasing shares of a stock with the expectation that the stock price will increase in the future.
-
In long selling, the investor is betting that the stock price will increase, and they will be able to sell the shares they purchased at a higher price than they bought them for.
-
The critical underlying concept of long selling is that the investor is exposed to potential losses if the stock price decreases instead of increasing.
Examples:
-
An investor buys 100 shares of XYZ stock at $50 per share. The next day, the stock price drops to $40, and the investor sells the shares. The investor has lost $1000 ($50 x 100 – $40 x 100).
- An investor buys 200 shares of ABC stock at $40 per share. The next day, the stock price rises to $50, and the investor sells the shares. The investor has made $800 ($50 x 200 – $40 x 200).
Misuses of Long Selling:
Insider trading:
-
Long selling can be misused when corporate insiders, such as executives or employees, use privileged information not available to the public to make profitable trades. For example, in the 2001 case of Enron, executives were found to have made large profits through insider trading of the company’s stock.
Market manipulation:
-
Companies can manipulate the stock market by artificially inflating the price of their own stock through long selling. This can be done through false or misleading statements about the company’s financial performance or future prospects.
Misuse of Short Selling:
Naked short selling:
-
Naked short selling refers to the practice of selling short without first borrowing the shares or ensuring that the shares can be borrowed. This can lead to an excessive supply of a stock and a downward pressure on the stock price. For example, in 2008, the Securities and Exchange Commission (SEC) took action against several hedge funds for engaging in naked short selling of financial stocks during the financial crisis.
Short and distort:
-
Short and distort refers to the practice of short selling a stock and then spreading false or misleading information about the company to drive down the stock price and profit from the short position. This is a form of market manipulation and is illegal.
It is important to note that while the misuse of long and short selling can have negative effects on the stock market and individual investors, not all short selling or long selling is inherently harmful or illegal. Both practices can be used as legitimate investment strategies when carried out in accordance with regulatory guidelines.
List of USA Companies who Misused of Short Selling
Here are some examples of US companies that have been accused of misusing short selling:
Bear Stearns:
-
In 2007, the investment bank was accused of misleading investors about the health of two hedge funds that were heavily invested in subprime mortgages. Bear Stearns shorted the subprime market, profiting as the market declined, while their clients lost billions of dollars.
Outcome of the Allegations
- Bear Stearns: The investment bank was eventually acquired by JPMorgan Chase in 2008. The Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) launched investigations into the collapse of Bear Stearns and the hedge funds it managed, but no charges were brought against the company.
Lehman Brothers:
-
In 2008, the investment bank was accused of engaging in excessive short selling and spreading false rumors about the firm’s financial health, contributing to its eventual collapse.
Outcome of the Allegations
- Lehman Brothers: The investment bank filed for bankruptcy in 2008, causing significant losses for investors and contributing to the global financial crisis. The SEC and the DOJ launched investigations into the collapse of Lehman Brothers, but no charges were brought against the company.
Goldman Sachs:
-
In 2010, the investment bank was accused of betting against the mortgage market while simultaneously selling mortgage-backed securities to clients. The Securities and Exchange Commission (SEC) filed a lawsuit against Goldman Sachs, alleging that the bank had misled investors about the mortgage securities.
Outcome of the Allegations
Goldman Sachs: In 2010, Goldman Sachs agreed to pay $550 million to settle the SEC’s lawsuit, which was the largest settlement in the agency’s history at the time. The settlement did not include any admission of guilt by the bank.
GameStop:
-
In January 2021, a group of retail traders coordinated a short squeeze of GameStop, causing the stock price to soar and leading to significant losses for short sellers. The incident sparked widespread debate about the role of short selling in financial markets and the influence of retail traders on the stock market.
Outcome of the Allegations
- GameStop: The incident involving GameStop and the short squeeze of the stock has led to increased scrutiny of short selling and the role of retail traders in financial markets. The SEC and other financial regulators are examining the incident and considering potential reforms to prevent similar incidents from occurring in the future.
Countries Banned Short Selling and Declared it as Illegal
In response to financial crises, several European countries imposed restrictions or bans on short selling. These countries include France, Germany, Italy, Belgium, and Spain. The bans were imposed temporarily and were lifted after the financial crises passed.
Other countries outside of Europe that have imposed restrictions or bans on short selling include:
- South Korea: In 2011, South Korea imposed restrictions on short selling to prevent market manipulation and stabilize financial markets during the European sovereign debt crisis.
- Australia: In 2008, Australia imposed restrictions on short selling in response to the global financial crisis. The restrictions were lifted in 2009.
- Japan: In 2010, Japan imposed restrictions on short selling to prevent market manipulation and stabilize financial markets. The restrictions were lifted in 2012.
It is important to note that while some countries have imposed restrictions or bans on short selling, the practice is still legal in many countries and is widely used as a legitimate investment strategy. However, regulators continue to monitor short selling activity and may impose restrictions or bans if they believe it is necessary to protect the stability of financial markets.
About The Author
