Occasionally I like to bet. Nothing serious but once in a while I gamble on the results of a football game.  Sometimes I even bet against my own team in the perverse belief that, if they lose, at least I get a bottle of wine out of their failure.

The teams do not know I am betting and, unless I have engaged in massive bribery (unlikely for a £10 bet) my wager has no impact on the result of the game. It is an asymmetrical event, the outcome of the match affects me (happy or with a bottle of wine), but I don’t affect the match. The same would be true even if I bet £10 million.

From the start of the recent stock market decline another form of gambling has come under the spotlight. This is going “short” on a stock. Going short is a bet by which someone sells stock they do not own in the belief they can buy it back later at a lower price and so make a profit. In essence they are the reverse of the average investor who buys shares in the hope they will increase in value. Short sellers need the value of a share to fall to make a profit.

Shorting is a risky activity. As the seller does not own the stock they have to borrow the shares they sell from an investor such as a pension fund. For this they have to pay a fee. They also have to return the stock and so, at some point, will have to go onto the market and actually buy the shares in the company.  This means that if the share price does not fall they are exposed to considerable loss.

Probably the most spectacular example of how big a loss can result was seen in October last year when short sellers of shares in Volkswagen AG incurred a €22bn (£18bn) loss in just two days.  This was because VW’s shares, in fact, rose by 348% and at one point it became the most valuable company on earth, worth more even than Exxon.

The problem for the short sellers was that only a limited number of VW shares were available to trade and so, when the share price started to rise, those who had bet on it falling had to buy in order to cover their short positions and limit their losses. The influx of forced buyers into the market forced the shares up astronomically.

Yet short sellers can also make significant profits and have, in the view of some, become one of the demons in this downturn. Unlike the asymmetrical nature of a sport's bet, short selling has an element of symmetry as the person shorting can have an affect on the share price. This is because, if there are more people selling than buying a company’s shares, price is likely to fall.

In June last year HBOS shares were significantly short sold ahead of a rights issue. In less than a week the stock lost more than 14% of its value, eventually dropping below the price of its forthcoming rights issue. The FSA in the UK considered this short selling to be destabilising the market and moved to temporarily ban shorting. Following the FSA announcement, HBOS shares rose 13.6% to close at 321.75p.

But is short selling so bad? Is there actually the evidence to show it harms rather than helps markets?

Clearly some short selling is simply illegal. Sometimes unfounded negative rumours about a company have been spread by people who have gone short on its stock in order to push share prices down and so make a profit. On the other hand, people have also ramped up a share’s value by putting out false good news.

Additionally “naked short selling” is often prohibited.  This is the selling of shares where the seller does not actually have possession of the stock he is selling.

But what about legal short selling?

Returning to the HBOS example, whilst it is true that immediately after the ban HBOS prices did rise, they soon recommenced their death spiral. On this occasion rather than short sellers driving the price down, it was long term investors who had lost faith in the bank. Indeed shortly after the takeover by Lloyds TSB, HBOS losses for the year were revealed as a staggering £10 billion (compared to a profit of a little over £4 billion in 2007). The short sellers had been proved right, the banks shares were overvalued.

To take the sports analogy further, not to allow people to take a negative view of a company’s share price is a bit like only being allowed to bet on one team in the football match. It is illogical.

Furthermore, short sellers can actually take some of the hubris out of a stock market boom. By identifying shares that are being grossly over valued, the short seller can take some of the heat out of the stock.  By effectively acting as a pressure valve short selling can reduce the risk of market bubbles and the share price crashes that inevitably follow.

There is also a benefit for the pension funds and insurance companies that lend out their shares. These investors hold shares for long periods and therefore the kind of short term fluctuations, within reason, do not affect them and they make money for their clients from stock lending. .

The FSA’s September ban on the active creation or increase of net short positions in the stocks of UK financial sector companies expired on the 16th January 2009. A further requirement of  disclosure to the market of significant short positions in those stocks was extended until 30 June 2009 but was amended, so that once a disclosure has been made, additional disclosures would only be required if a short position changed significantly.

Short selling can be used in an abusive destabilising way; however it is a legitimate part of the capital markets. Indeed it can be considered a positive force when used in investment strategies (such as hedging) and risk management activities.  Furthermore it can contribute to market liquidity and helping ensure pricing efficiency.

International Standard setting bodies such as the International Organisation of Securities Commissions and the Committee of European Securities Regulators are working on developing and harmonising short selling regulatory regimes not banning them.

Those that claim they are the devil’s own spawn that need to be eliminated from the market may make better sound bites but they will not help us out of the present crisis, an orderly, efficient capital market will.