The Stock Exchange - Selling Short

We have mentioned that market makers look to buy at a low price and sell on at a higher price. The assumption is therefore that they believe that the price is going to rise. If there is a general belief that prices are going to rise, it is termed a 'bull market'. The rumour is that it is called this because a bull tosses its victims up in the air!

Image: This sculpture of a bull used to be outside the New York Stock Exchange but after the crash in 1997 it was deemed to be a bad omen and was moved further down the road! Copyright: Myles Davidson, stock.xchng

However, there may be occasions when a market maker thinks that prices are going to fall. In such circumstances s/he might also be able to benefit. A belief that prices are going to fall is referred to as a 'bear market'. This term is thought to derive from the fact that bears 'bear down' on their victims.

In this situation the market maker might take advantage of the period of time between making deals and settling accounts by selling shares s/he does not own in the expectation that the price will fall. Such a situation might also arise if a stockbroker wishes to buy more shares than the market maker currently has available. The market maker might agree to sell 250,000 shares even if s/he only has 175,000 available at that time. This practice is referred to as 'selling short'. There are normally three working days allowed to settle accounts so the market maker has some time to be able to get the shares s/he needs when selling short.

Let's look at an example. A market maker thinks the price of shares in Marks and Spencer is going to fall from its current level of 290p. S/he agrees to sell 150,000 shares at 290p. Six hours later, s/he buys 150,000 shares at 287p thus making £4,500 when the funds for the sale are received.

You may be asking what happens if they cannot buy the shares they need to fulfil their obligations? The simple answer is that they are in big trouble! The motto of the Stock Exchange is 'My word is my bond' so if a deal is agreed the expectation is that it will be honoured. In general the market maker will always be able to get the shares they need but may have to pay a price for it and so could end up making a loss on the deal rather than the expected profit! That is all part of the risk and skill involved in the work of market makers.

There is also the option of 'borrowing' shares off another market maker to make good any possible shortfall and then paying the market maker back when the shares have finally been secured.

The screen based trading systems in use at the Stock Exchange mean that the market maker does not have to be at the Exchange at all - they could be anywhere in the world. The screen based systems such as Proquote allow the market maker to see exactly what is going on in the market. The Proquote system (amongst others) allows the trader to see the latest prices, the volume of shares transacted, a record of recent deals, the time of transactions, the price at which the trade took place and so on.

Image: A system like Proquote allows market makers around the world to monitor what is happening to shares. The screens are constantly updated to reflect what is happening in the market. Source: Proquote

After 'Big Bang' the Stock Exchange used a system called the Stock Exchange Automated Quotation system (SEAQ). In 1997 this was replaced by the Stock Exchange Electronic Trading Service (SETS). This latter system enhances the facilities available for traders especially with regard to shares that have heavy volumes of trade. Some of the more popular companies have millions of shares traded each day and the SETS system allows dealers to place orders to buy shares in the company at particular prices rather than looking for quotes from market makers. In essence it works like this:

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