Investors enticed to sell themselves short

By ELLEN READ markets writer

The Stock Exchange's pursuit of a more active stock market is leading it to encourage investors to sell shares they do not actually own - a popular technique overseas for trying to profit on a falling market.

As part of this week's proposed rules revamp, the exchange is planning to remove the requirement that it must approve those shares which can be short sold, and has reduced the margin of cover - effectively the cash deposit - a client must provide (from 20 per cent down to 10 per cent).

Short selling means selling shares that are not actually held in anticipation of a price fall, then buying them back at the lower price.

"It's a very underdeveloped part of the New Zealand market. Shorting is an extremely valid trading strategy," exchange managing director Mark Weldon said yesterday.

"It does happen here but it's not a well-promoted part of the market."

The rationale behind the changes is to increase the liquidity of the local market and encourage overseas investors to trade here.

Short selling is common practice in the US but not here where the market is illiquid and many companies are tightly held by a relatively small number of shareholders.

Weldon believes encouraging the practice will help entice overseas investors who now ignore the local market as it doesn't provide for trading strategies - such as short selling - that they like to use.

"Shorting stock," Weldon explains, "enables you to short one stock and long another so if you have a liquid shorting market it allows you to hedge more accurately."

Weldon defends the practice of short selling saying that what has driven some of the falls in the US - commonly blamed on short sellers - is actually trading driven by computer programs. "There are a lot of large dealers with programs set up that will have buy and sell [triggers] at certain index levels."

Profiting from price falls

In sharemarket jargon, most investors are "long" - they have bought shares in the hope of selling them later at a higher price, and banking the difference as profit.

Short selling is a little more involved.

It is an attempt to profit from falling share prices, rather than the usual approach of hoping for a rise.

An investor "borrows" shares from another investor's account, via a broker, and then sells them - but is obliged to replace those shares at some stage in the future.

The hope is that when it is time to replace the shares, they can be bought back at a lower price than they were sold for. The difference - minus commissions and other costs - is the investor's profit.

The risks are high; if an investor sells short and the share price goes up instead of down, he or she still has to buy to replace the borrowed shares, and there is no limit on how high a share's price can rise.