Question

Discuss the rationale and main criticisms of short-selling restrictions.

Answer 1

In short selling, one sells the security first and buys it later. The expectation of the seller is that security price will fall and there by seller can earn the difference.

For example, Let us assume that the shares of companby A arae trading at 100$. There is some bad news about this company in the market. Seller read this news and assumed that the company share will fall and decide to short 100 shares.

1. Share actully fall to 95 and seller squares off its position by buying back 100 shares. Profit of 500$

2. Shares remains same and seller only lose transaction cost.

3. Shares rose to 105 and seller has a loss of 500$ plus transaction cost.

Now while doing short selling transaction the broker asks for certain margin amount. This margin amount will be used to settle the transactiion in case of seller runs into situation 3. Now if seller has decided to execute very large short selling operation and invested his entire capital in the form of margin. But the prediction turned out to be wrong and shares rises a lot. In this case seller do not own the shares(No delivery) and hence can not give shares to buying party at the end of the day.

This is the reason why short selling is limited.