Is short selling evil?

 

I’ve both witnessed and participated in debates on whether or not short selling stocks is wrong or harmful to companies or market participants.

Short selling is essentially betting that the price of a commodity, stock, bond, or currency will go down in the future. It works through borrowing the stock from a broker, buying it back at a lower price, and keeping the difference.

According to Investopedia.com ‘Short Selling’ is: The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.[1]

For the purpose of this conversation I will mainly refer to stocks, since that’s what most people will be familiar with, and where much of the contraversy lies.

While the same general principles could be applied to the trading practices and principles other traded goods, the perceived effects of shorting are different for each.  For example, while an investor may see the value or necessity of keeping the price of corn low because it keeps his cost of living at a reasonable  level, he may not appreciate the falling price of his company’s shares.

Stock markets tend to move up and down in waves. When a stock becomes popular or sought after, more people wish to buy it. The more they wish to buy it, the more the seller can charge the buyers. This in turn pushes the price of a stock up, as people now wish to get in on a stock that is moving up in price. As this chain of events continues, the price continues to rise. This is how some investors enter long trades. In a long trade, you buy the stock, and pray that it goes up forever. At least, that’s what I do.

At some point this stock may begin to go down. Maybe it went from sixty to eighty dollars. Let’s say a third of the people holding that stock decide to sell it when it hits eighty. Because there’s been this sell off , there’s now an abundance of them for eighty. In order to sell shares faster, a few will be willing to unload for seventy nine or seventy seven. The new price of seventy seven, may push others to sell theirs at lower prices as well, causing a fall.

Those that argue against shorting may say that adding short sellers to an already falling price will only drive the fall faster and lower. The fast drop may give less people time to get out of their trades, as well as cause the company to be undervalued in its share prices, scaring off investor funds.

A few market dips and crashes have been blamed on ‘shorting’ in the past.  In  the early 90’s England was in the European Exchange Rate Commission. At the time it was being pressured by other European countries to devalue it’s currency in relation to others in the region In or forced to leave it. After continued pressure, england finally decided to float it’s currency and began losing value. On September 16, 1992, George Soros (famous investor) shorted the British Pound. Through leverage, he put up US$10 billion, and earned US$1 billion by shorting the pound. Soros later became known as “the man who broke the pound.

Soros also took blame for financial trouble in Asia when his company shorted the Thai baht and the Malaysian ringgit early in 1997. Soros defended the trade by saying, “Prime Minister Mahathir of Malaysia accused me of causing the crisis, a wholly unfounded accusation. We were not sellers of the currency during or several months before the crisis; on the contrary, we were buyers when the currencies began to decline – we were purchasing ringgits to realize the profits on our earlier speculation.”[2]

Some countries have gone as far as banning short selling. Several European nations banned short selling during the recent credit crisis in attempt to curb volatility. In 2011 Korea banned the practice after hitting a record high among foreign investors. The United States has considered a ban on shorting, and will likely bring up the discussion again in times of market panic.[3]

One practice that marred short selling is the scam of ‘naked short selling.’ a naked short is when a broker authorizes a short selling transaction without ensuring that the securities are actually available to be borrowed for the short. Shorting shares that aren’t available could unfairly drive down the price of a security. I think we can all agree that this is unfair and rightly illegal. [4]

Another illegal practice associated with shorting is to sell short, then initiate a smear campaign to devalue the security being shorted.

Despite the many inferred flaws, selling short can benefit traders and market prices. For one, shorting can be used to hedge risk. A trader can reduce the potential risk of his portfolio by having some long, and some short trades. This way, if the market tanks, and the pieces of all stocks in his portfolio fall, the short sales will reduce his loss by giving him some gains for the short portion.

Some believe that shorting is a way to prevent securities from becoming overpriced, keeping them in a reasonable range,perhaps preventing them from reaching prices that will trigger a a price crash.

Before beating up on short sellers, we should first consider the fact that the potential risk in a short sale is infinite. If you buy a stock ‘long’ (betting the price will go up) for $10, the most you can lose is $10, Once it gets to $0, that’s it. The ride’s over. However, the potential gain on that stock is infinite. It could eventually go up to $100 or even $500. On the other hand, if you short the same $10 stock , the most you can earn is $10. If the price falls to $0 that’s it.  The loss potential in a short sale can be more than you borrowed. If the same stock jumps to $100, you’ve now lost $90 plus service charges.

The fact that the risk is higher in a short sale shows that it’s not some free ride that allows people to profit off of a company’s drop in share prices. Shorting isn’t a tool that can be used effectively without considering and managing its risk potential.  The risks in short selling are also what make the practice  much less common than buying long. The hedging potential of using shorting in a portfolio is also something that I believe should be available to those savvy enough to use the tool wisely.  I believe this tool should be available to those willing to use it, as the general risk of loss from holding short trades dwarfs the potential for abuse.

There is abuse in all forms of finance. Banning a practice because some abuse it may be going too far. Perhaps they have a point, but I have yet to come across a convincing argument as to why it should be banned across the board.

My ears are open.

Tahric Finn

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1.) Short selling. Investopedia.com. June 25,2012. http://www.investopedia.com/terms/s/shortselling.asp#axzz1yhpGQppE

2.) Soros, George (1999). The Crisis of Global Capitalism: Open Society Endangered, 2nd ed., PublicAffairs, ISBN 1-891220-27-4, pp. 208–209.

3.) An Overview of Short Selling. Investopedia.com. April 24, 2012. June 25, 2012. http://www.investopedia.com/financial-edge/0412/An-Overview-Of-Short-Selling.aspx#axzz1yhpGQppE

4.) ibid.

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