The specific action taken by Britain's FSA against short-sellers was sparked by worries that market operators were forcing shares in HBOS, the country's largest mortgage bank, artificially lower.
The bank is in the process of raising £4 billion (Dh28.8bn) through a rights issue, offering almost 1.5 billion new shares at 275p apiece. Last week, the regular market price of HBOS stock fell below 275p. If investors do not take up the HBOS rights at 275p, the underwriting banks will have to do so at that price. So short sellers have been working on the assumption that the lower they can push the market price the more likely it is that the underwriting banks will be left with huge amounts of stock that they want to clear at a discount.
The short sellers would buy these discounted shares to close their positions – and book their profits. But what if things were to change? Perhaps a sovereign wealth fund might come along, hoovering up cheap shares to acquire a strategic long-term stake in HBOS. In such a scenario, to use the market parlance, you would have "burnt shorts" or a "bear squeeze", resulting in a rapid increase in the HBOS price.
In fact, the theoretical risks associated with being short far outweigh those of being long. The reason is simple: if you buy a share at £1 the most you can lose is your investment, £1; but if you short a share at £1, your potential losses are infinite since the stock might head for the moon.
For that reason, those specialising in shorting stocks tend to do their homework. Whatever the FSA says, expect downward pressure on HBOS to resume in the near future.