Share prices are what people are prepared to buy and sell for.
If the most
desperate buyer will not meet the price of the most
desperate seller, there are
no trades. At some point either a buyer
increases his offer to get the cheapest
available shares or a seller
reduces his price to match the biggest available
offers. After such
a deal, the gap between offers to buy and sell returns,
but
centred at a new price.
Pretend I decide to sell shares I do not have.
I
sell to the the buyers with the largest offers until they are
satisfied then
sell at the new lower price.
They say 'the cheque is in the post', I say 'the
share certificates
are in the post' and everyone is happy.
Existing
investors see the gap between offers to buy and sell
increasing. Perhaps they
get nervous and offer to sell at a lower price.
If not, a fake news story may
be needed to prod them into action.
I need the investors to drop their
price below what I paid.
That way, I can spend some of that cheque in the post
on real
shares that I can actually put in the post so I do not get
caught.
This is an effective strategy but can go horribly wrong. Pretend
you
guess what is going on, and have a huge pile of money in the bank.
You
wait for offers to sell to fall almost to the price I want, then you start
buying. If you think I am getting nervous, you buy faster to exhaust
any offer
I might be about to take. You put your shares up for sale
at a hefty price. The
other investors start to wonder what you know,
and increase their prices to
match.
Now I have a choice: sell my car so I can afford to buy
at your
price, or admit I was selling shares I did not have.
You let me sweat for a
bit, then increase your price. To get out of trouble
now, I have to sell my
house. If you are feeling nasty, you increase
your price again. Buying my way
out now costs more than I have -
the solution is obvious: sell more shares I do
not have, use
the money to buy my way out of your trap and pray I do not get
caught the same way twice in a row.
In reality, defending against a
short seller is difficult. You have to
spot what is happening really fast. You
have to have lots of money
in the bank. You have to keep that money tied up in
shares until
I break. If you get too greedy, I might just take the money and
run -
after all, I have cash from all those imaginary shares I just sold.
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