Why Short Selling Is a Good Thing for the Stock Market and Investors Large and Small

We noted earlier the hubbub over a hive of little investors on Reddit outfoxing some big Wall Street firms who had made massive short bets on the stock of GameStop. Some of the narrative around this event has painted short selling as a secret, evil practice only available for the big guys. But none of that is true.

First, a quick refresh on shorting a stock: it is where the investor sells a stock he does not actually own. Typically, his broker locates some stock that he can borrow in order to sell it. The investor has to post money or securities as collateral, to guarantee he has the resources to buy the stock back from the market at some later date, to repay the party from whom the broker borrowed the stock. The reason the investor does all this is because he expects the price of the stock to go down, so he will make a profit by buying it back at a lower price than he initially sold it for. 

This sounds a bit complicated, and it is something I have never done, but pretty much anyone with a reasonably sized account at most brokerages can do it. It is definitely not restricted to big firms. (Big firms are probably able to do this on more favorable terms than the small investor, but that does not change our point here). Selling short is inherently risky – – if a stock goes up and keeps going up and up after you shorted it, you can lose a lot of money when you buy it back.

Short selling is sometimes painted as something nasty, since the investor is “hoping” for the stock to go down, even rooting for the company to fail. That is not really fair, since an investor may simply feel a stock has become overvalued and is due for a correction. This has nothing to do with ill-will towards the company or towards other investors.

There may be cases where big firms do a lot of short selling, which can create downward momentum in the stock price, and then try to drive the price down further by spreading negative rumors about the company. This is called a “bear raid”.  Concerted action like this, and spreading false information with the intent to influence prices, is illegal, and can result in fraud charges by the Securities and Exchange Commission. But that is not the norm.

So, we have made the case that short selling is a legitimate trading strategy, which is not malevolent in itself. But beyond that, experienced financial voices point out that having short selling in operation helps the overall markets actually work better than they would if it were forbidden.

Short Selling Helps Stabilize Markets

Let’s imagine a market with no short selling. A stock is going up and up, and investors get carried away with enthusiasm and keep buying at very high, unrealistic prices, bidding the price up even further, since it is hard to find anyone who wants to sell in light of the euphoria. It all works until it doesn’t. Eventually the price will start coming down, and stockholders may start panic-selling as the price drops. But then there may be no buyers willing to “catch a falling knife”, and so the price plunges way down in a big undershoot.

If short selling is allowed, then when the stock starts to get overvalued, the short sellers provide some selling to counteract the euphoric buying. This can help keep a stock from going crazy on the upside. Perhaps more importantly, when the stock price has dropped and sentiment has turned negative on it, the shorts will want to cover by buying the stock and taking their profits, since it is always risky to keep holding a short position. This provides some buying which can help keep the stock price from dropping off a cliff. So the activity of short sellers provides liquidity, and hence more stability and (hopefully) more efficient price discovery in the stock market, both on the upswing and downswing.

Also, behind the scenes in stock exchanges there are “market makers”, whose role is to constantly stand ready to both buy and to sell a given stock. When an individual investor like you places a buy order for, say, 20 shares of Apple with his broker, it is the market maker who typically supplies those 20 shares from his inventory. There may be times when the market maker temporarily runs out of Apple shares in his own stash. In order to keep the overall markets humming, he may borrow some shares to sell you, which is technically selling short. He then buys more Apple shares to repay the source he borrowed from.

Finally, investors often pair short sales with a long position or option in a related stock or commodity, as a hedging strategy. For instance, they might buy (i.e. go long) the bonds of a particular company, but short the common stock. This means that they are not totally short in a one-sided bet. (The thesis for this trade might be that the stock price will drop more than the bond price, but if it all goes the other way, the rise in the bond price may mitigate losses on the shorted stock). Having shorting as an option helps motivate and facilitate trading which would not otherwise occur, which again makes for greater liquidity and presumably more efficiency in the overall market.

All this seems like a net good for both large and small investors. Short selling gives savvy investors further reasons to be glad: The level of short interest in a stock is a matter of public record, so an investor can gauge at a glance what the overall sentiment of the so-called smart money is toward a stock. If a stock is heavily shorted, but starts to go up instead of down, the savvy investor has the option of jumping into a “short squeeze” to potentially make some quick bucks, as happened with at least some of the WallStreetBets group on Reddit with GameStop a couple of weeks ago, assuming they pulled out some of their gains before that bubble popped.

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