The One Minute Case for Stock Shorting

What is stock shorting?

Stock shorting is a method of profiting from a decline in a stock’s price. It is the opposite of investing long, where the investor profits from a rise in the stock’s price. “Going long” or hoping for a gain in the stock’s price is the more familiar method of investing. However, “going short” and profiting from a decline in a stock’s price is an equally valid method of investing.

How does stock shorting work?

Shorting a stock is a little more complicated than going long where a stock is simply bought and then sold later for either a gain or loss. Shorting stock first involves borrowing it from an existing owner. The short seller pays a fee to the owner to borrow his shares. Upon borrowing it, the stock is immediately sold and the proceeds are kept in the short seller’s brokerage account. When the short seller wants to close out his position (or the shares’ owner wants them back), he buys equivalent stock in the marketplace and returns the shares he borrowed back to the owner.

If the stock has fallen in value, he makes a profit that is the difference between the price at which he borrowed the stock and the price at which he bought it back. Conversely, if the stock has risen in value, he suffers a loss since he has to buy back the stock at a higher price than he borrowed it for.

Short sellers fulfill a crucial and productive role in financial markets:

Short sellers bring to light valuable information about poorly run companies.

Short sellers have a strong incentive to uncover poorly run companies. If a short seller successfully discovers ahead of others that a company is destroying value through incompetence, bad luck or even criminal activity, he profits by shorting the stock and publicizing the information. Short sellers are similar to good investigative journalists. They make more money if they can “scoop” others with information that will drive the stock down.

It is this aspect of short selling that many company managers, regulators and others find discomforting. Yet these same managers and regulators have no problem when an investor uncovers a successful company. Why should they be opposed to someone who does the opposite, and uncovers the overvalued, incompetent, lazy or even fraudulently managed companies?

Short sellers help capital go to the best companies.

By taking financial capital away from poorly run companies, short sellers free up money that can go to the best-run companies. Short sellers are the other half of the value-creating process of financial markets whereby capital is continually re-directed to those who can put it to the most valuable use.  The existence of short sellers means that capital will more quickly flee the poorly run companies and thereby become available that much faster for the better-run companies. The profit that a short seller makes is his reward for aggressively uncovering the poorly run companies.

Short selling is challenging.

Short selling is not for everyone for the simple reason that stocks generally tend to go up. During the 20th century, stocks gained 9% a year on average, although there was significant yearly variation. Stocks do not decline in value across the board for long periods of time. Because of this, short sellers must time their moves well, and attempt to short at the top of a stock’s move and then close out the position when it has hit bottom. If the short seller mis-times his moves, he will lose money. Such precision in timing is less important for long investors because stocks generally go up.

It is a misconception that short sellers can unfairly cause stock prices to go down.

This is the most common misconception about short sellers. However, short selling is only likely to be successful if companies truly have problems. If a seller shorts a strong or improving company, he will lose money. It is a misconception to think that short sellers (or long investors) can cause stock prices to deviate for meaningful time periods from their true values.

The only power a short or long investor has comes from being right. When he is right, he is rewarded for helping to bring true information to the marketplace. When he is wrong, his wealth is dissipated and his ability to invest further is diminished. If he is wrong often enough, all of his wealth will be dissipated and his ability to influence stocks will be nullified.

Conclusion: Short selling is moral and should be permitted.

Short selling creates value by making the capital markets work more efficiently. Short sellers help bring negative information about companies to the market. By doing so, short sellers provide liquidity to the market and help capital to flow away from the worst companies and toward the best companies. Without short sellers, markets would be less liquid and more violatile. Long investors would have more difficulty selling their positions, and the lack of liquidity would make it more difficult for companies to raise funds in public offerings.

To restrict short selling not only harms the efficiency of the markets, but it violates the right of stock owners to freely dispose of their shares as they see fit. Because their shares belong to them, it is their property, they have the right to do what they want with them, including loan out their shares to short sellers. Conversely, short sellers have the right to borrow those shares.

A proper understanding of short selling demonstrates the valuable and productive role it plays in the financial markets.

Further reading

9 Comments

Filed under Economics

9 Responses to The One Minute Case for Stock Shorting

  1. Tim Swanson

    That was one of the clearest explanations I have come across. Especially hard-hitting was:
    “By taking financial capital away from poorly run companies, short sellers free up money that can go to the best-run companies.”

    I’d like to see one on the bullied concept of “gouging” too.

  2. James

    Galileo: I know this is an elementary question, but how does a company lose money if its stock price diminishes (per the quote in the preceding comment)? If no short explanation is possible, is there a good book or essay you could direct me to for the answer?

  3. Good question, and my apologies for not responding sooner.

    A rising or falling stock price does not directly provide or take away money from a company. It only affects the company when it needs to raise new money from investors in a stock offering. So, successful short selling where it is accompanied by a fall in a company’s share price, reduces the amount of money a company can raise in a future stock offering.

    Conversely, if a company has a rising stock price, it can raise more money in a future stock offering.

    A rising or falling stock price affects a company’s ability to finance future projects.

  4. Companies only make money directly from stocks when they initially sell them to the public in the primary market. When stocks are traded between individuals – the secondary market – companies do not obtain/lose capital. Their stock price just inhibits their ability to raise needed funding in the future.

  5. “It is a misconception that short sellers can unfairly cause stock prices to go down….” – is a nice evasion of fact. Stock price is not based on company performance, it is based on the perception of that performance. Just as short sellers can expose an inflated stock price based on perception so they can create a perception that the stock is in trouble – just by shorting it.

  6. Pingback: The One Minute Case against the SEC | The One Minute Case

  7. Nick said, “Just as short sellers can expose an inflated stock price based on perception so they can create a perception that the stock is in trouble – just by shorting it.”

    Yes, that is a true in a limited manner. However, if there is no other confirming information on the validity of the short and, in fact, there is plenty of information that contradicts it, such a strategy cannot work. For example, to short a growing, robust company would be self-destructive. A foolish short investor could temporarily push the stock price down somewhat, depending on how much money he has to dissipate on the effort. But, other investors who observe independently that the company is, in fact, healthy and growing, will take the opposite trade. They will go long while he is trying to short the stock and they will overwhelm him because most investors care about making money by investing on facts, rather than throwing money away in efforts that despise the facts.

    As a result of the long investors coming in, reality will rather quickly trump artifice, and the manipulative short investor will find he has lost money as the stock price rises against his short.

    After he loses money in that debacle, he will have that much less capital to try to manipulate the markets again. If he keeps at it, he will dissipate all his capital.

    In this manner, the market rewards objective truth and punishes those who invest on whim or in an effort to manipulate the market, and thereby minimizes their impact on the market.

    So, yes, the stock market reflects investors’ *perceptions* of reality, but if those perceptions do not accurately reflect reality, such investors will be minimized and ultimately wiped out.

    Objective, truthful information about companies is rewarded in the profits that successful investors make. Attempted manipulation of stocks contrary to the actual fundamentals of a company cannot work, long-term. It can only give the appearance of “working” over the short-term, and only then at the expense of the financial destruction of the manipulator.

    The unrestricted stock market (with proper laws enforced against fraud) is the best method of identifying companies and investments that are worthy of receiving investors’ capital. It is a mechanism for each individual investor to bring to bear his own, independent judgment of the facts, and it rewards him for getting it right.

  8. Michael Groves

    Not a well-thought through essay.

    Companies raise captial by issuing *new* shares – the trading of existing shares is of little concern. Of course, in order to make the purchase of new shares attractive, there needs to be a mechanism for holders to sell them on at a profit (or a loss, of course).

    Buying shares (new or existing) in a company is buying an ownership in that company – the right to participate in its profits in perpetuity. That’s a healthy way of investing , where in the long term the rewards are directly related to the performance of the company. Selling one’s ownership in the company is slightly less “pure”, in the sense that it’s realising now, the *predicted* value of the company’s future profits (or lack thereof, of course).

    Unfortunately, the existence of an efficient market for trading in shares has led to forms of trading that are more speculation than investment. Day trading, for example, would seem to add nothing useful to the economy. It’s nothing more than betting on random, or psychological movements in the market, generally unrelated to any realistic changes in the fundamentals of the company’s prospects.

    And that brings us to shorting. In shorting a stock, there is not even a pretence of investing money or creating wealth. All it does is provide a multiplier effect, so that any change in the perceived value of the company’s revenue streams results in much bigger swings in the share price.

    The increased volatility of the share market is in no-one’s long term interest. As the author of the original article points out in later comments, “Attempted manipulation of stocks contrary to the actual fundamentals of a company cannot work, long-term. It can only give the appearance of “working” over the short-term… This much is true. But in the short term,the realistic valuation of the company is blurred by the comparatively wild swings in share price caused by speculation. Not only that, but the profits of the shorting “investor” are often totally disconnected from the company’s past, present or future performance – driven instead by panic or misinformation.

    The fact that in the long term, the truth will out, is only partly mitigating. The increased and unwarranted risk and volatility of the share market is too high a price to pay, considering the only benefit of shorting accrue to the lucky (or shrewd) bettor.

    If a company’s prospects are judged poor, let those who own it divest themselves of their shares if they wish, at the best price they can get. Let those who *don’t* own it not profit from the already poor position of those who do, as this is merely exploitation without any redeeming feature for the economy as a whole.

  9. darter22

    Not unrestricted. Bring back the uptick rule.

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