Short selling – why it helps

September 20, 2008 at 12:57 pm | Posted in regulations, Stock market | Leave a comment
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First: Short selling means selling shares you don’t actually own. Traditional investors use their cash to buy shares, and at some later point, sell the shares back into cash, hopefully at a higher price for a profit. There are two transactions – first, they convert cash (which they have or borrow) into shares. Later, they convert the shares back into cash, and use the cash to pay off any money they borrowed to finance the transaction. A short seller basically reverses this order. First, they borrow shares they do not own, and sell them, converting into cash. Later, they use the cash to buy the shares back, and return the shares to the lender.

Say you were convinced that stock A will fall from $50, where it is currently trading. If you own the stock, you can sell your holding, and, suppose the stock did fall to $30, you could feel good that you avoided the $20 / share loss. But what if you don’t own the shares? How do you profit from your convictions? Well, you borrow a few shares, and sell them at $50. Later, when the stock falls to $30 you can buy them back, return the borrowed shares to the lender, and pocket the $20 difference (ignoring transaction costs, cost of borrowing the shares and taxes). That is basically what a short seller does.

The market combines tens of thousands of trades to arrive at a stock price. In other words, todays price reflects the combination of the information and beliefs that every participant in the market has about the stock. Some people are selling the stock – their views suggest they expect the stock to fall. Others are buying (for every sale, there is a buyer), and they expect the price to rise. Today’s price is just the momentary equilibrium between the forces propping the stock up and those pushing it down.

Banning short sales forces the market to ignore the information that the short sellers are bringing to the market. The supply of shares for sale will now come only from those who own the stock and are willing to sell. So the supply has fallen. Nothing prevents potential buyers from buying, so the demand curve remains the same, and the price equilibrium is artificially high because of less supply. So you have got rid of a good chunk of the sellers in the market, and a bunch of buyers who think the stock would have been cheap at $30 but wouldn’t touch it at $50 are also left out of the market. In the meantime, short sellers who have already sold the stock (who may or may not have wanted to sell more) know that the new equilibrium price is going to be higher than they expected, and the stock won’t fall as much as they had expected. So they try and buy back the stock to return the borrowed shares, pushing the stock up quickly (and temporarily). As the price rises, any one who is short the stock is losing money, so they all head for the exit, buying up shares to close their positions (so they can return the borrowed shares and square things off).

The rush of short sellers to close their positions is called a short squeeze, and it causes the stock price to overshoot. But then, once it is done, you have fewer sellers, and fewer buyers. Liquidity falls, and pricing becomes less efficient.

Suppose the short seller was right – The $50 stock is really worth $30. (We don’t really ever know what a stock is worth, but if the share price does reach $30 some day, then the market agrees, at least for that moment, that the stock is really worth $30). Eventually, that information will spread in the market, so, eventually you should see the price get to $50. But short selling helps you get there quicker. It can also cause the stock price to overshoot, and fall too low before recovering. But, generally, all this plays out relatively quickly. If the price overshoots, some of the short sellers will come in to buy and return the borrowed stock, locking in their profits. Other investors will find a price they cannot resist and will also buy in, bringing the stock back up.

All this is not perfect. But a fast-falling stock does not entice as many people as it falls, than one which gets from $50 to $30 over months instead of days. So, without short sales, more people will come in on the way down, get burnt, and stay away from the stock for months after it has bottomed. With, they come in later in the fall, hopefully find a great entry point if the stock has overshot, and feel reassured by the bounce back from the low to the more natural equilibrium point, providing better buying interest over time.

I do favor setting some limits on short sales – For example, what percentage of total shares can be lent out to short sellers. I am not sure what those limits are, but I would like to protect against an over-reaction. But over-reacting is better than not reacting enough – I would err on the side of the short sellers.

With short sellers, the market moves faster – but it also moves truer.

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