Why Short Sell?

Benefits of Short Selling

Q:‘Indeed short selling may have a calming effect on price movements’ – What calming effect!?

A: When buying investments, there is the tendency for people to buy when they see prices rising, and to accelerate as the rises accelerate, so as ‘not to get left behind’. Similarly, when selling, people aim to sell early when prices drop, before they collapse. This provides a certain amount of positive feedback, which can allow a big rally or big drop to feed upon itself. At the same time, falling prices discourage buyers, after all why by now, when you can buy at the bottom, and rising prices discourage sellers.

The reverse is true with short selling – as prices fall, the risk/benefit ratio of a short position worsens – there is therefore a motivation for short sellers to cover their position by buying shares as soon as they have taken their fill of profits, as waiting for the bottom is potentially risky. A similar reverse principle applies for entering a short position.

As a result, short sellers, tend to prevent rallies from going too high – as they provide a mechanism to sell shares when they become ‘overvalued’, even if the momentum of the bulls is trying to carry the market upward. Similarly, during periods of rapid price falls, shorts have a motivation to cover, and help prevent excessive falls.

In markets where short sellers are restricted (notably China) market movements are much more volatile – moves of 6 or 7% in the main index are common, with individual shares fluctuating by much more than that.

Banning short selling may help prices rise, but it also helps prices fall harder and faster. What it does not do is stop overvalued markets falling – although it may delay the inevitable, and make it happen more dramatically.

Q:What is ‘naked’ short-selling?

Is making money the sole purpose of short-selling?

A: While some investors will use short-selling solely to take a bet on the direction of a stock, it is also commonly used by sophisticated money managers such as hedge funds to “hedge” their position – ie, to offset possible adverse price movements in a related asset. A number of retail investors are also increasingly using shorts as a hedge. This means they are protecting other long positions with offsetting short positions. Also, option traders will use shares to offset the risks of options they have bought or sold.

Market makers cannot make proper markets if they are not allowed to short stock. To facilitate Nasdaq or OTC market trading, market makers always run short positions. Otherwise there is no market. When market makers receive an order to supply stock they often do not have the stock on their books so they short sell to the buyer and hope to acquire the stock at a later date at a more advantageous price. No short selling would lead to less competitive prices at which investors can deal or worse deals may only be possible where sellers are directly matched with buyers. To get a perspective of this try trading a third-line stock in the USA to realise just how difficult it can be to buy or sell shares.

The current furore over short selling should be put into perspective: it was ALWAYS illegal to naked short sell. A correctly placed short sell order was ALWAYS preceded by a ‘locate’ call to the broker by the short seller. If the broker said he could locate stock to borrow, the short sale went ahead. Otherwise it did not. Late settlement, for whatever reason, is always tightly monitored. Repeat offenders risk account closure. However if the brokers themselves merely informed the short seller they could locate but in fact could not, then it was not the short seller’s problem anymore but the broker’s. And that is what seems to have been happening.

Traders will short sell for two distinct reasons; to speculate and profit from selling high or overvalued shares with the intention of buying back to close the positions at a lower price in the future and to hedge risk.

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