Mlp investments, mlp investing, mlp, mlp funds - SteelpathAuthor : Jim Knight

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How Does Short Selling Affect the Market

Before embarking on a discussion on how short selling affects the market, it is important to clarify what short selling is.

Short selling can be defined as “the practice of selling assets, usually securities, which have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender.” In other words, the short seller benefits from a decline in the value of the assets between the dates of selling and repurchase. (Note: There are some costs associate with borrowing the assets and paying any dividends declared on those assets within that period.)

On the other hand, if the assets increase in value, the investor loses money. This is because, unlike earlier, he will have to spend more to acquire those assets than he got by selling them. This strategy of “shorting” or “going short” is the exact opposite of the strategy of “going long” where the investor profits from an increase in asset value.

There is another version of short selling, an extreme version if you will. It is called “naked short selling”. This is “the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale”. Naked short selling has been illegal in the US since 2008.

Now, since short selling is posited on asset prices falling, the practice has often been blamed for stock market crashes. The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, precipitating a major banking crisis which included the collapse of almost every private bank in Scotland and a major cash squeeze in London and Amsterdam, the leading financial centers during those days.

One of the earliest such instances on the US was the Wall Street Crash of 1929 which led on to the Great Depression. This led Congress to enact the uptick law banning short sellers from selling shares during a downtick – the short had to be either at a price above the last traded price of the security, or at the last traded price if that price was higher than the price in the previous trade. It remained in effect till 2007.

In September 2008, a flurry of short selling, especially naked short selling, contributed to excessive market volatility, leading to a three-week ban on shorting for 799 financial companies.

During this period, Germany, Ireland, Switzerland and Canada banned short selling leading financial stocks, and France, the Netherlands and Belgium banned naked short selling leading financial stocks. Australia went for a complete ban on the activity.

The stock markets are not the only ones affected by short selling. The collapse of the Dutch tulip market in 17th century and the “breaking” of the Bank of England by George Soros when he sold short more than $10 billion worth of pounds sterling are also examples of the extreme effects of short selling.

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What are Stock Options and How Do They Work

It is easy to understand how stocks work in the ordinary sense – you buy low and sell high to make money. Options, on the other hand, present some difficulty in understanding. So, here’s a primer on what stock options are and how they work.

An option is a contract giving its owner the right to buy or sell an asset at a fixed price on or before a given date. In case of stock options, this asset is a number of stocks of a particular company, usually 100. Note that it gives the “right”, but is not an “obligation”. In other words, the owner may choose not to exercise that right.

At this point, it may be advantageous to learn about some of the vocabulary associated with options:

1. Strike or exercise price – the fixed price specified in the contract.2. Expiration date – the date beyond which the option cannot be exercised.3. American/European option – An American option may be exercised anytime before the expiration date, but a European option can be exercised only on the expiration date.

There are two kinds of options – call and put.

Call option – This gives the owner to buy 100 stocks of a particular company at a particular price within a particular period. For example, if the owner purchases a Microsoft call option with a strike price of $100 and an expiration date of 20 February, he gets the right to buy 100 stocks of Microsoft at the rate of $100 per stock on or before 20 February. Therefore, if the market price of Microsoft stock on that date is more than $100, he has got a good deal and the option is said to be “in the money”.

Therefore, it is obvious that he is going to exercise that option. On the other hand, if the market price is less than the strike price, the option is said to be “out of the money”. In such a situation, the owner will not exercise the option and his loss will be the purchase price of the option, which is substantially less than the stock price.

Put option – This gives the owner to sell 100 stocks of a particular company at a particular price within a particular period. For example, if the owner purchases a Microsoft put option with a strike price of $100 and an expiration date of 20 February, he gets the right to sell 100 stocks of Microsoft at the rate of $100 per stock on or before 20 February. Therefore, if at any time on or before 20 February the price of the stock is less than $100, he can buy 100 stocks from the market and sell them using the option.

Therefore, when the market price is below the strike price of a put option, it is said to be “in the money”. If the market price is higher, then any stock already purchased can be sold for the market price instead of exercising the option, which is said to be “out of the money”.

This is a basic overview of what stock options are and how they work.

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