- Paolo Parboni
Main Takeaways
Shorting can be used for risk-management or as a tool to solve discrepancies between price and intrinsic value.
Short-selling can be unethical when it is used for deceitful market manipulation in a ‘short and distort’ scheme.
Just like buying or being bullish is not a moral virtue, selling or being bearish is also not sin.
The GameStop phenomenon that occurred in January2021 sparked some controversy on the topic of short-selling. While short-selling has been around for a while, a number of people have gained disdain for it. Most notably, Elon Musk called shorting an “evil” practice and “a means for bad people on Wall Street to steal money from small investors”. Are the criticisms valid? Is short-selling unethical and should it be banned?
What is Short-selling?
In the most general sense, being short simply means that you think the price of something will decrease. There are different ways to be short, including short-selling, derivatives and insurance. Let’s focus on short-selling for now.
Short-sellers borrow securities from a broker, sell them in the open market, and subsequently aim to repurchase the same securities at a lower price to return them to the lender. If successful, the investor will keep the difference as profit. If the price of the underlying keeps rising, the investor is theoretically exposed to infinite losses.
For instance, stock XYZ has a price of $100, but in reality its true price should be closer to its intrinsic value of $40. The short-seller will borrow stock XYZ from a broker and sell it for $100. Ideally, the price will drop to $40, and the short-seller will buy it back and return it, keeping a $60 profit. However, it’s possible for the price to keep rising; it could go to $110, $150, $200 or higher. Nobody knows when the price will stop increasing. Since the short-seller has to buy back the stock at some point, the broker will either force him to close the trade by buying back the stock or to put up more collateral (a margin call) so that he can remain short.
The Viciousness of Short-selling
One of the reasons people say short-selling is immoral is that you are profiting off someone else’s failure, and therefore rooting for bad things to happen. This is not the right way to think about shorting. Instead, one should view it as a tool to solve a discrepancy between price and intrinsic value. As you may know, an asset’s price and its actual value (i.e. what the asset is selling for and what its worth) are not always the same.
Using the example above, company XYZ is worth $40. If it’s priced at $100, then shorting is simply betting that its price will eventually reflect what it's actually worth. If the investor is wrong, then his trade will be unprofitable because the price will not decline. If the investor is right, then the price will theoretically decline to reflect the current state of the firm. In the end, it's the company’s fundamentals that typically dictate its future, not the short-seller’s bet. Think about it: Blockbuster did not stop existing because there were too many shorts, Netflix took their customers. Not convinced? Then perhaps the benefits of short-selling will be more persuasive.
Fraud Exposure
Short-sellers are often at the forefront when it comes to taking down those who are actually acting unethically: fraudsters. During the dot-com bubble, energy company Enron engaged in one of the largest accounting frauds of all time. Short-selling specialist Jim Chanos took a short position and helped exposed the scandal. This is just one of many examples of the value that short-sellers provide; the same has happened with companies like Lehman Brothers or, more recently, Luckin Coffee (if you’d like to read more about the most scandalous collapses in finance, check out this article by Sara Oco*koljic). Thus, short-sellers can actually protect smaller investors, rather than “steal” their money.
Risk Management
The ability to be short is a valuable tool for risk management. As mentioned previously, derivatives and insurance are often used to hedge risk. For example, an investor can buy a put option on a large position to truncate the downside risk. Another case would be a commodity producer that is willing to lock-in a price using a futures contract. The producer is essentially short, otherwise he would wait for prices to rise further. As for insurance, whoever is underwriting the policy is long risk and whoever is buying is short risk.
In general, in a derivatives market there is a seller for every buyer. For a long to exist, there must be a short on the other side. This is necessary, and as described above, beneficial for those who want to transfer risk to another party. Again, there is nothing inherently evil about any of these strategies.
Shady Shorts
Things take a turn for the worse when investors short a stock and then spread lies and misinformation so that the price goes down. The formal name for this is ‘short and distort’ and it's an illegal form of market manipulation. It is the mirror opposite of a ‘pump and dump’ (a situation in which someone buys a stock and then inflates its price through misleading statements that are unrealistically positive). Both scenarios are considered securities fraud, which makes them illegal and perpetrators could be subject to fines and jail time. Short and distort does not make short-selling immoral anymore than a pump and dump would make buying a stock immoral. It's not the act of buying and selling that is frowned upon, but rather the wilful deception of others.
Another instance in which short-selling can be a problem is when it is “naked”. Naked shorting takes place when a share is shorted before borrowing it from somebody else. Remember that short-selling means an investor borrows a share, sells it and then buys it back at a (ideally at a lower price) to return the share. Naked shorts are troublesome because if an investor sells something that does not exist, then he might be unable to close his position. This is also illegal in the United States.
Chop, Don’t Stab
Overall, short-selling is just a tool, so it will be as good as the one who wields it. Blame lies with the user, not the instrument: a knife can be used to chop food or stab someone. While short and distort schemes certainly exist and can harm people and corporations, it is the lies and defamation that are the problem, not the shorting. A bet that someone else’s asset will decline in price is not an attack on the owner of the asset, but a wager that the asset will trade lower and eventually reflect its true fundamental value. Short positions are not only beneficial, but necessary for an efficient financial system. The idea that shorting is evil and unethical is therefore misguided.
