Why they hate short sellers

The ins and outs of the financial markets' latest scapegoat.

Every market and every game has its own whipping post.

In baseball, it's the umpire. At the gas pump, it's the big oil companies. And in the stock market, it's the short seller.

On Thursday, Sept. 18, British regulators banned short selling on the shares of 29 U.K. financial firms until January; they subsequently added four more companies' stocks to the list.

The U.S. Securities and Exchange Commission followed suit the next day, suspending short sales for 10 trading days in the equities of 799 financial service institutions.

Other countries, such as Canada, are mulling over a similar cease-and-desist order.

Slipping stock markets had regulators banning short selling in September. ((Mark Lennihan/Associated Press) )

With all the prohibitions flying around global stock markets, one gets the sense that the short seller is about as popular in the investment world as a plate of broccoli at a seven-year-old's birthday party.

"I hate short sellers! They should be banned from the market," said one e-mailer writing in a financial chat room.

Cashing in on falling markets

In fact, short selling is a pretty common way speculators make money in the modern stock market.

Essentially, these people make their coin by selling shares they do not own.  It might sound shady, but the transaction is all legal.

First of all, the person finds a buyer for the stock issue in question. Then, this seller borrows the shares from his or her broker or another investment house to hand over to the purchaser.

At some future point, say in a month's time, the investor needs to return what they borrowed to the investment house — in market jargon, it's known as "covering."

So the short seller goes on the open market, buys the stock and gives it back to the original lender.

The method by which investors make money on this transaction is the same reason they are so reviled by many stock traders; they make a profit only if the share price drops.

The math works like this: Suppose the "short," as this type of investor is known, sells a particular stock for $100. Then, a month later, the same shares are now worth $75.

The short seller buys back stock on the open market for the lower amount. But the investor had already received $100 for the same stock one month earlier.

In this example, the investor makes $25 — incurring only slightly more risks than if she had bought the shares hoping they would go up.

Gilded pariahs

Like real estate brokers, many investors often try to talk up the stock market as a buying opportunity no matter the circumstance and thus hate short sellers, who applaud falling markets.

Stock purchasers basically believe the shorting crowd is inherently evil, circling like vultures and picking away at good companies until their stock values begin to fall, causing panic in the marketplace and destroying fine firms.

Billionaire Philip Falcone, whose firm reportedly earned the equivalent of $536 million when the share price of distressed U.K. mortgage bank HBOS fell this month, is known as the "Midas of Misery" because of the 45-year-old's ability to make money in bad markets.

Stock speculator Jesse Livermore reportedly made $100 million US in the stock market crash of 1929.

Government worries

U.S. and other regulators probably did not institute trading bans on shorting stocks because of such long-standing prejudices.

Instead, these securities experts appear worried that short selling was injecting too much downward pressure on stock markets already brimming with bad feeling and teetering on the brink of a major collapse.

The fear was that nervous investors would interpret a mild drop in a company's share value as a reason to dump the stock in a reckless manner. 

U.S. Treasury Secretary Henry Paulson coupled a ban on short selling with a massive bailout to stem Wall Street's panic ((Pablo Martinez Monsivais/Associated Press))

The bans on short selling appeared to remove that negative pressure on stock prices and push back some optimism into stock valuations.

Of course, the same day government put a halt to shorting, Washington unveiled a new plan to remove bad debt from the balance sheets of ailing U.S. financial firms.

It's hard to know which weighed more on the markets, but regardless, on Friday the Dow Jones industrial average was up more than 300 points.