My Take On Short Selling

My Take On Short Selling

Short selling has been in the news quite a bit recently as a result of this whole “meme stock” debacle.  With the army of Reddit traders creating short squeezes in GameStop, AMC Theaters, and a few other companies the practice of short selling in general is being questioned.

This is partly because the media is framing this as a David vs. Goliath story.  A group of underground Reddit traders bully the big bad hedge funds of the world by creating a short squeeze that sends share prices soaring.

Hooray for the little guy!

This storyline isn’t entirely accurate though.  Melvin Capital made a lot of news for being short, but many other professionals and hedge funds made a lot of money benefiting from the short squeeze by being long.  There’s a report that Blackrock pulled in $2.4 billion on the trade.

Nevertheless, David vs. Goliath is an easy story for people to get behind.  And since it’s easy to root against a villain, short selling is coming under fire because that’s the side Goliath was on.

Short selling as a practice captures the financial spotlight every few years – usually during times of market turbulence.  It’s often used as a scapegoat for corrections, which nearly always leads to calls for some type of short selling ban or suspension.  That argument doesn’t have much merit, but the discussion attracts strong opinions anyway.  Elon Musk, for example, is notoriously in favor of outlawing short selling.

I’ll explain my take on short selling in this post.

 

I’m Biased

To be totally clear, my opinion is a little biased when it comes to short selling.  I am in favor of free markets in general, but also spent the first seven years of my career as a trader & manager on the securities lending desk of a major national brokerage firm.  Those of you who know what means likely have your mind made up already about whether short selling should be legal.  I’ll try to explain it here for those who don’t.

 

What Is Short Selling?

The quick explanation of short selling (aka “shorting) is when you sell a security without owning it first.  Which can make a lot of sense if you expect the price of a certain stock to go down.

For example, if you shorted 100 shares of Apple stock at $100 per share your broker would lend you the shares to sell first.  You’d then sell the stock for 100 * $100 = $10,000, and wind up with that amount of cash in your account.  You’d also owe your broker back the stock you borrowed.  If the price went down like you expected, you’d make some money.  If it went up you’d lose.

Let’s say your hypothesis was correct, and Apple’s share price fell from $100 to $50 per share.  You initially sold 100 shares for $10,000 in cash.  But now the shares you owe your broker are only worth $5,000.  You could buy the shares back at $50 each, return them to your broker, and pocket the $5,000 left over.

Short selling is an aggressive maneuver though.  If the price went in the other direction, say to $150 per share, the shares you’d owe your broker would now be worth $15,000.  Even though you have $10,000 cash from the initial transaction, you’d owe $15,000 of stock and be down $5,000.

There’s no limit to the amount of money you can lose selling short, either.  The farthest a stock can fall is to $0, when a company goes bankrupt.  If you’d have shorted 100 Apple shares at $100 before they went bankrupt, you essentially get to keep the $10,000 in your account since there’s nothing to return to your broker.  But in the other direction, share prices can keep going up and up without limit.  Apple at $150 would mean you owe $15,000 of stock to your broker.  Apple at $200 would mean you owe $20,000.  And on it goes.

 

It All Depends on the Borrow

Note that the Apple example above begins with you borrowing the shares from your broker.  Any time you sell of stock (long or short), there’s a faceless buyer out there in the universe on the other side of the trade.  When you sell long you deliver the shares you own to the buyer.  When you sell short you have to borrow them first.

Years ago the rules around short selling were pretty lax.  Brokers could let anyone and everyone short whatever shares they wanted, with no regulatory obligation to deliver them.  Running with our Apple example, if your broker allows you short 100 shares without owning them the broker will need to deliver those 100 shares when the trade settles.  If your broker isn’t able to find them, they “fail” on the transaction.  While the buyer expecting the shares might be pretty (very) unhappy with your broker, there wasn’t much regulatory risk for failing.  This enabled “naked” short selling, where shares are sold short with no expectation that they’ll ever be borrowed.

The rules have evolved though.  These days brokers face stricter regulatory requirements & harsher penalties when they fail.  Which has effectively reigned in naked short selling.  It also means that brokerage firms need to pay close attention to short sale orders, so they’re not penalized for failing.  This being the case, all brokerage firms have a “securities lending” group responsible for this.  They approve short sale orders on stocks they can deliver, and must deny orders on more obscure stocks they can’t.

As I mentioned, I started my career on a securities lending desk that borrowed & loaned shares to facilitate short selling.  Which is why I’m a little biased.

 

Arguments Against Short Selling

The primary argument against short selling is that it can be used as a tool to illegitimately drive down stock prices.  There are numerous examples of short sellers targeting reputable companies by spreading fake rumors & attempting to drive their stock price down.  Rather than shorting the stock and sitting back to wait for the rest of the market to align with their expectation, abusive traders will sometimes use short selling to force downward momentum.

Long shareholders can do this too of course.  Holders of any company can spread rumors about buy out offers, strategic partnerships, or other potentially positive news.  But in practice it’s much easier to drive a stock price down than it to prop the price up.  Even though naked shorting is no longer allowed.  In general, fear is simply an easier sell.

I suspect this is the crux of Elon Musk’s argument for banning short selling outright.  In his mind, his organizations are trying their best to create useful products and services for the public, create value for shareholders, and generally do good things for the world & for human beings.  Then out of the blue a group of people tries to drive you out of business for no other reason than they can make money off of it.  They sell your stock short, start spreading false rumors, and do everything in their power to drive your stock price down.  This is clearly not good for society.

 

Arguments For Short Selling

Though short selling can absolutely be used nefariously, there are major benefits too.  The main example is price discovery.  Above we used the example of a good company doing good things in the world, and short sellers spreading lies in an attempt to drive the share price down.  What about when it’s the corporation that’s lying?

As we’ve seen over and over again, corporate executives manipulate share prices too.  (Think Enron, WorldCom, etc.).  Executives are compensated based on share price and company performance, so there’s an incentive to exaggerate positive information and suppress negative information.  Short sellers are often the first party to uncover such fraud.

Citron Research, for example, is a notorious short seller that publishes in depth research reports on fraud and “terminal” business models.  They claim to have uncovered at least a dozen cases of corporate fraud in the last few years before it was identified by any regulatory authority.

The point of this argument is that without the ability to sell stock short, your only choice as an investor is whether to own the stock or not.  You may buy shares any time you wish.  But you may only sell when you own them first.  Without shorting there is no direct mechanism to bet that the price of a company will fall in the future.  Sure, there are options, futures, swaps, and other instruments to accomplish this, but I’d expect limitations on such derivatives if selling short were outlawed.

When your only choice is whether or not to own shares, there is naturally less downward pressure.  While that’s great for companies genuinely doing good things for our society, it also allows poor companies and fraud schemes to drag out far longer than they should.

 

Should It Be Legal?

Let’s not forget why stock markets exist in the first place: they’re meant to provide equity capital to companies trying to grow.  A well functioning market is one that provides ample liquidity, where investors can buy and sell shares quickly and easily for a fair price.  The more efficient the market, the more it helps a country’s economic growth, and the better off its citizens tend to be.

Short selling improves market efficiency.  Without it, prices of individual companies tend to rise & deviate farther from their fair value, which is precisely what we’re seeing in GameStop & AMC.

There is precedent here too.  Numerous other countries around the world have experimented with short sale bans over the years, the most recent being Korea and several EU countries during the COVID sell off last March.  But after examining the evidence regulators concluded that it did not produce any useful result.  Before that, a study examining short sale bans around the world during the mortgage crisis of 2007-2009 concluded that bans:

  1. Were detrimental for liquidity, especially for stocks with small capitalization and no listed options;
  2. Slowed down price discovery, especially in bear markets, and;
  3. Failed to support prices, except possibly for U.S. financial stocks

Even though short selling can be used unscrupulously, the benefits of liquidity and price discovery cannot be overstated.  The evidence supports this.  Short selling should absolutely be legal.

 

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