Short selling stock!

Markets always over-react, on the downside as well as the upside, and an over-reaction (not regular daily moves or healthy corrections) on the downside results in a plunge.

This is something even Middle Eastern markets have to face. In general, psychology is the most determining factor of market prices, especially with regard to short term trading.

You may ask: How does Jerry know? Well, I have been a market maker on the trading floor of the option exchange in Amsterdam and I still own a market makers company in Holland. This company, Summer Traders Ltd, is a member of Euronext, is supervised by the Dutch authorities and has a clearing contract with Goldman Sachs.

Middle East sold short

Because of my experience, I am familiar with collapses such as that of the Middle Eastern markets. Nowadays I am also Managing Director of Mercurious, a company that offers and delivers consulting and training with special focus on derivatives. It is for this business that I spend a lot of time in Dubai, and it was there that I discovered that short selling in the Middle East is impossible.

Yet selling stock short is essential. In the US markets, for example, it is possible to borrow stock then sell it to the market and hope for a bear market so that the same stock can be bought back at a lower level in order to lock in profit.

The price risk involved in buying and selling shares is equal, therefore short selling stock should not be considered more dangerous than buying these assets. Furthermore, when a market consists of both bears and bulls (opposite strategies), the market becomes more mature and more competitive and a more stable financial market emerges. This is a development that Middle Eastern markets have yet to make.

It is essential for the further development of financial markets to sell stock short as some exchanges want to introduce derivatives. Futures and options can be better priced (small bid-ask-spread) if market makers are able to hedge their positions. In order for this process (the hedging the risk of their positions) to run smoothly, they have to continually buy or sell the underlying value.

More to be done

So, despite great developments, there is still a lot to be done for many markets. Once the system, including its basics (principles and standards) has been optimised, these markets will then be ready for further development, such as the listing of options.

Apart from not being able to sell short, there is another reason for the current collapse. As I mentioned above, psychology is the most determining factor for market prices and for their over-reaction, but there is a second factor that is responsible for the current plunge.

The fact that (private) investors are able to borrow money from banks to invest in financial markets helps create over-reactions, especially when markets go down and people receive margin calls and have to eliminate their positions. This results in more selling power, and every time the market reaches a lower level somebody else's stop-loss order is hit, and this repeat process accelerates, creating up in a snowball effect.

The more mature a market becomes, the less volatile it is. Take FOREX trading as an example of a mature market. Trading in currencies is extremely competitive: 24 hours a day, 7 days a week, and it's been going on for decades.

On the other hand, a bubble, like the internet bull market which ended in 2000, occurred in a fairly new sector. IT, internet and telecom faced their own process of maturing and the market went along with this development.

The problem with new markets, however, is that prices are not based on fundamentals. Nobody yet knows all new market fundamentals, and even fundamentals are prone to change, so psychology plays an even greater role. Please remember this.