-Written by Yeajin Shim
Charlie’s father is the owner of multinational chocolate producing company. He already knows from his father that this company is going on a sale next week. Having this information, he sells his chocolate to your friends at $2 without actually giving them chocolate and promises to give it later instead. A week later, chocolate price drops to $1 as he already knew, so he buys chocolates and gives them to his friends then. He earned $1 from each friend since he sold $2 virtual chocolate which he bought at $1 later on. This is the basic concept of short-selling.
Short-selling is the sale of stocks that is not owned by the seller or that the seller has borrowed. Short-selling is motivated by the belief that the value of a stock will decline, like in the Charlie’s case, which can be bought back at a lower price to settle payment of the share. If I borrowed 100 shares and sold them I’m now 100 shares “short” since I have sold something that I didn’t have in the first place. The term “short-selling” is derived from this principle (reference: Investopedia). There are two types of short sale: naked short-selling and covered short-selling. Naked short-selling refers to the practice of short-selling without first borrowing the stock, whereas covered short-selling refers to short-selling after borrowing the share. So, like everything else, short-selling has both pros and cons. Because its adverse effects were recognized as big a problem the ban had been in place since Oct. 1, 2008. Amid the financial crisis, short-selling was accused of bringing down stock prices and increasing market instability. As of 2013, after five years later, financial authorities in South Korea lifted the ban on covered short-selling of financial stocks starting Nov. 14 which was possible due to the belief that the stock market had been stabilized and there is a need to bolster trading activity.
So, in Charlie’s case, you earned $1 from each of his friend. But what if the price of the chocolate rose unlike what he has expected? Then, he loses his money. Since the risk of loss on a short sale is theoretically infinite, short-selling should only be used by experienced traders. It also has the risk of distorting stock price and making stock market volatile. However, it has also some good effects. According to analysis of the U.S. and U.K. markets, short-selling ban caused overpricing of stocks and deteriorated market liquidity and quality. Most other countries banned short-selling amid global financial crisis in 2008 but as it is a universally accepted investment technique, they also have lifted the ban as the economy has stabilized. The ban on covered short-selling was lifted but naked short-selling will continue to be prohibited according to the FSC.
“We expect this will help vitalize the capital market and boost market transparency,” the FSC said. “We want to minimize any ill effects of short-selling and maximize its good function by enhancing indirect regulations and lifting the ban.” Along with the lift, the FSC mandates short sellers in the Korean market who own greater than 0.5 percent of outstanding shares to report on their short-selling stocks to give regulators more access to data on short-selling activities.
Short-selling will probably be adopted further as Korea’s capital market develops more. Many investors as well as the FSC anticipate that this measure will help boost trading of financial stocks. It is evaluated that the FSC did the right thing but stronger regulations should be imposed as the short-selling bears a great risk. Let’s see how it works out!
By. Yeajin Shim (email@example.com)