Why a ban on short-selling is pointless

Four European countries have recently introduced short-selling bans. It's a completely pointless exercise, says Tim Bennett. Here, he explains why, and names three ways you can still profit from a bear market.

It isn't often that a regulator steps in to try and stop a bubble developing. But give them a bust and they always start meddling. Look at France, Italy, Belgium and Spain. They weren't bothered when bank share prices were clearly far too high. But now they are falling, they've banned short-selling. This makes no sense. Here's why.

What is short-selling?

"Buy low and sell high" is one of investing's oldest mantras. But there's another way to make money sell high first and then buy back lower later. Buying a share for, say, £10, and selling it for £12 makes a £2 profit. But so would selling first for £12 and buying back for £10 afterwards. That's short-selling.

To do this a hedge fund might borrow 10,000 bank shares from a pension fund for a fixed period. It will have to return the shares plus a fee at some point in the future. In the meantime the borrowing fund arranges a sale of the shares on the open market for, say, £2 each, waits hoping the price will fall, and buys them back a few days later at, for instance, £1 each. If it works the hedge fund makes a profit of £10,000 and then returns the borrowed shares to the pension fund. In theory everybody wins the pension fund gets a lending fee on shares that would otherwise have sat in its portfolio doing nothing. The hedge fund makes a profit from its short sale. So who loses? Regulators think it is the bank and other shareholders, hence the short-selling ban. This logic is wrong.

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Short-sellers are just the messengers

All a short-seller is doing is driving prices down to a more realistic level and taking a lot of risk to do so. If, in between borrowing and returning stock its price rises instead of falls, you can get trapped in a very expensive short squeeze: you have to buy back the stock in the end regardless of the price. That's why short-sellers only act if there are very good reasons to.

A ban reduces liquidity

Regulators are not just driving out speculators. Many funds use short-selling as a legitimate way to hedge existing positions, often via derivatives contracts such as put options. By reducing liquidity you actually increase volatility, as a smaller number of trades go into what is called price formation' (the process by which the market sets prices).

A partial ban is pointless

Why just four countries? Why just certain stocks? And why not extend the ban across all instruments that facilitate short positions, including all derivatives?

It just doesn't work

America tried to ban short sales on 880 stocks for three weeks after the collapse of Lehman Brothers. That group of stocks fell 26%. The wider market fell 22%. And in Europe stocks have seen some of their biggest falls ever since the ban began. So far the latest ban has done nothing but make the regulators look silly.

Three ways to profit from falling prices

Short-selling, in the way I describe it above, is nigh on impossible in the British market for a retail investor. However, here are three alternatives.

First, inverse exchange-traded funds. These offer a return of the inverse movement in an index or sector. As such, they offer a way for a retail investor to play a falling market without getting bogged down in derivatives. However, watch out for the catch daily repricing. Say, for example, an index, with a value of 100, rises 10% the next day, 10% the day after that and then falls 20%. It will end day three at a level of 96.8. That's a fall of 3.2%. An inverse ETF offering twice the inverse move will drop 20%, then another 20% before rising 40%. Starting at 100, that leaves it at 80 after one day, 64 after two days and 89.6 after three days. That's an overall loss of 10.4%. Not much that's either double, or inverse, about that.

Next up, spread bets. These are a fast and tax-efficient way to bet on markets. You might bet, say, £10 per point on the FTSE 100 falling from a level of 5,000 points. Every point below that level makes you £10. So if you close out the bet when the FTSE is at 4,900 points you make 100 points at £10 each or £1,000 (ignoring bid-to-offer spreads). However, if the market rises instead of falling, you will lose £10 per point. For more on this, see our spread betting page.

Last up are put options. These give you the right to sell, say, 1,000 shares at a fixed price within a certain period. The charge for this is a non-refundable premium paid up front. As the price of the share named in the put option falls, the value of the option rises. So having paid a small premium for the option you can sell it on for a higher one provided share prices fall before it expires. The downsides are that the premium is non-refundable and the payoffs are fairly complicated. That's why options (and even their retail equivalents covered warrants) are best left to the professionals.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.