Short selling

An investor can make money through short selling if he
determines that the price of a stock is likely to decrease in the
future.  The following example illustrates how it works.

Let us assume that the shares of XYZ corporation are
presently $80 a share.  If you expect the price per share to
decrease, you borrow from your broker 100 shares, sell them in
the open market and receive $8,000 (100 x $80).  A week later,
the price goes down to $70, you then buy 100 shares on the open
market and return the loaned shares to your broker.  Your cost
will be $7,000 (100 x $70).  Your profit will be $1,000 (8,000 –
$7,000).  (Commissions and interest charged by your broker for
the loan of the stock were ignored in this example).

However, the above example is not typical, not all investors
who engage in short selling fare as well.  There is an
interesting psychology here, short selling of a particular stock
tends to increase as the price of that stock decreases, thus most
short selling is usually at the bottom of the stock’s price.  For
this reason, many investors who engage in this practice can be
hurt.

Say that you borrow from your broker 10 shares of a stock;
presently, the price per share is $10.  You sell them in the open
market and receive $100.  A week later, the price is $12; you
decide that it is risky to wait, you buy 10 shares on the open
market for $120 and return the loaned shares to your broker.
Your loss will be $20 plus commissions and interest.  Of course
you could have waited, but it is a risky strategy, the price can
go even higher and you risk increasing your loss.

Again we can see that the existence of a floating price
brings an element of gambling (by buying the stock when the price
is low, investors are too close to the edge and are more likely
to get hurt).

Hedge funds

There is no strict definition of hedge funds.  They might be
thought of as high-end mutual funds.  A hedge fund is, generally
speaking, the pooled capital of usually 100 or fewer partners
(rich individuals or institutions), led by a single manager or a
small team.  They are subject to few regulations, if at all; many
are registered in offshore havens, even though they are managed
from places like New York and London.  They can invest their
capital any way they like, from government bonds to highly
speculative stocks.  Since they don’t need to file any reports,
we can only guess at their numbers.  As of 1994 (this is the only
information I could find, even though dated, it will still give
you a good idea of the magnitude of the problem), it was
estimated that there were between 800 and 900 hedge funds with
total capital of $75 – 100 billion.  Since hedge funds borrow
aggressively, they can take positions from 5 to 20 times their
paid up capital, meaning that in total they can control anywhere
from $375 billion to $2 trillion in securities.  Compounding the
problem is the fact that they move very quickly in and out of
investments.  As we shall see, hedge funds has had a substantial
impact on the markets.

They were responsible for much of the turbulence in the
European Monetary System in 1992 and for the U.S. bond market
debacle of 1994.  Since they borrow so heavily from banks, a
really disastrous year for the speculators could do serious
damage to the broad financial system; central bankers and
regulators may face the choice of a bailout or systemic collapse.
Finally, with the vast sums of money at their disposal, there is
the concern that hedge funds operators could manipulate the
markets.

Hedge funds are a case in point, they clearly show the
potential for damage if we do not find a substitute to the
floating price of shares.

Sources

1) How to Read and Understand the Financial News
Gerald Warfield
Harper & Row, Publishers, Inc.
New York
1986

2) Wall Street, How It Works and for Whom
Doug Henwood
Verso
New York
1997

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