Short selling has long been a controversial practice. It involves selling borrowed shares in the hopes of repurchasing them later at a lower price and profiting from the decline. Critics argue short selling destabilizes markets, enables manipulative bear raids, and should be strictly limited. However, proponents argue that short selling improves market efficiency and price discovery by factoring negative information or sentiment into asset values. They contend that short selling ultimately creates more stable markets through increased liquidity and healthy skepticism.
So what are the merits of these two opposing perspectives on short selling? Does shorting stocks really create an unproductive downward bias, or is it a valuable mechanism for discovering fair asset prices? The debate has significant implications since restrictions on short selling affect market quality and returns for all investors. This article will examine arguments on both sides, look at real-world examples, and review what the research says about the impacts of short selling.
Key Takeaways
- Short selling, an oft-misunderstood practice, often plays a vital role in market strengthening.
- Unlike the traditional investing strategy of buying low and selling high, short selling allows investors to sell securities they do not own, with the intention of buying them back later at a lower price.
- Critics of short selling often argue that it can exacerbate market downturns, create undue pressure on companies, and allow some traders to profit at the expense of others' losses.
- Proponents argue that short sellers can add liquidity, reveal stocks that are priced higher than their actual worth, and help bring their prices closer to their true value.
The Positive Impact of Short Selling
While short selling is sometimes portrayed as a negative force in markets, it can strengthen markets and benefit investors in several key ways. Specifically, short selling facilitates efficient price discovery, improves liquidity, and promotes healthy skepticism among investors.
Facilitates price discovery
One of the main benefits of short selling is more efficient price discovery—the process by which the market determines the price of an asset based on supply and demand dynamics. When short sellers identify securities they view as overvalued, they sell those assets and put downward pressure on prices. This incorporates negative information and more realistic valuations into asset prices. By betting against irrational hype or bubbles, short sellers can prevent unjustified price spikes and bring the market back to reasonable value levels. In this way, their trading activity acts as a counterweight to overly optimistic investors and overpricing.
Improves liquidity
Short selling also enhances liquidity in the markets. When short sellers sell borrowed shares, the supply of shares available for trading increases. This added volume makes it easier for buyers and sellers to execute trades in the market. Stocks and other assets with high short interest tend to have tighter bid-ask spreads and lower transaction costs. The increased trading activity makes markets more efficient and integrated. Short selling also helps create unified pricing for related assets by facilitating arbitrage across markets.
Promotes investor skepticism
Short selling also promotes investor skepticism and critical thinking. Short sellers have a vested interest in rooting out negative information and exposing corporate malfeasance. This motivates more thorough investment analysis over the practice of passively buying hyped stocks. When investors can directly profit from identifying overvalued assets, it incentivizes healthy scrutiny of companies and avoidance of irrational exuberance. The scrutiny that comes with short selling can expose red flags like accounting irregularities and fraudulent activities within companies, acting as an additional layer of market oversight. Acting as watchdogs, short sellers check corporate misconduct and poor management.
Short selling as a common practice has been around since at least the time when stock markets emerged in the Netherlands during the 1600s.
The Negative Impact of Short Selling
Although short selling can improve market efficiency, critics point to several ways it may negatively impact markets and companies. Specifically, short selling may exacerbate stock declines, enable manipulative bear raids, and cause temporary artificial inflation in shares.
Can accelerate declines and increase volatility
Excessive short selling activity can potentially accelerate market declines and downturns. When stocks are already falling, a surge in short selling can create selling pressure that drives prices even lower. This extra downward momentum can turn otherwise ordinary declines into full-fledged crashes. Heavy short interest increases volatility as short sellers must cover their positions by buying back shares. Critics argue this added volatility undermines investor confidence and stability in the markets.
Can lead to "short attacks"
Short sellers are sometimes accused of coordinating bear raids to deliberately sabotage stocks. This involves spreading negative information and ganging up to short the stock with the goal of spooking other investors to sell. The fear is short sellers can essentially engineer a self-fulfilling prophecy and profit from the artificial decline they created. When short attacks cause viable companies to fail, it harms employees, shareholders, and the economy.
Can lead to "failures to deliver"
Another issue arises when short sellers fail to actually borrow shares before selling them—an illegal practice called naked short selling. This can result in a failure to deliver (FTD), where short sellers cannot locate enough borrowable shares. The resulting "failures to deliver" lead to temporary artificial inflation in shares that should not exist. Critics argue this distortion enables market manipulation and improperly distorts true supply and demand.
Profits from others' losses
A philosophical objection to short selling is that it allows investors to profit directly from other investors' losses. When short sellers bet against a company's success, they profit if the stock declines, even if fundamentals do not justify it. This ability to gain from price declines often bothers critics who view markets as meant to allocate capital efficiently rather than facilitate speculative attacks for private gain at the expense of businesses. They argue short selling incentivizes predatory practices that hurt companies, employees, and investors for self-interest.
Example of Short Selling in the Market
A prominent example of short selling that improved market efficiency occurred during the dot-com bubble in the late 1990s. As technology and internet stocks became wildly overvalued amid hype about a new economy, short sellers identified the bubble. They bet against dot-com companies they saw as having poor fundamentals. Short sellers focused on dot-com stocks with shaky business models and minimal revenues that could not justify their sky-high valuations. For example, technology stocks like Pets.com, GeoCities, and eToys.com had low revenues but market caps in the billions of dollars.
When the bubble inevitably popped, the short sellers' skepticism was validated. Many internet companies collapsed as the mania ended, vindicating the short positions. By profiting from identifying overvalued stocks, short sellers helped prevent the misallocation of even more capital to fundamentally worthless businesses. Their contrarian position to the dot-com frenzy brought prices back in line with reality.
Research on the Effects of Short Selling
Several academic studies and real-world experiments have shown that short sales tend to improve market efficiency overall.
A 2012 study by Charles Jones, a former Columbia Business School professor, analyzed short-sale restrictions imposed on stock markets following the 1929 crash. He found that shorting bans introduced in the 1930s actually reduced market liquidity and increased volatility. This finding was repeated more recently. In 2008, the SEC banned short sales on certain financial stocks to prevent manipulation and avoid worsening the market crash. However, a 2013 article published in the Review of Financial Studies found this actually increased volatility and worsened market quality for those stocks.
Another recent paper provides a systematic review of several studies on the determinants of short selling and the implications for information distribution, real economic decisions, financial reporting, and external auditing. The paper highlights that short sellers act as important information intermediaries and influence various corporate decisions as a result.
While some studies dispute these findings or suggest that further context is important, the predominant research indicates that short selling improves price discovery and market quality on average. This empirical evidence helps support the value of allowing short selling to take place with appropriate safeguards against manipulation.
Is Short Selling Legal?
Yes, short selling is legal in the U.S., and anyone with a margin account can engage in shorting stocks. The practice of short selling was one of the central issues studied by Congress before enacting the Securities and Exchange Act in 1934, but Congress made no judgments about its permissibility at the time. Instead, Congress gave the Securities and Exchange Commission (SEC) broad authority to regulate short sales to prevent abusive practices. During times of market crisis, when stock prices are falling rapidly, regulators have stepped in to either limit or prohibit the use of short selling temporarily until order is restored. However, naked short selling remains illegal and constitutes a form of securities fraud. When short selling, a trader needs to first locate and borrow a stock that has been determined to exist and can be borrowed.
How Does Short Selling Work in Practice?
In a short-sale transaction, traders borrow shares from a brokerage firm in their margin account and agree to return equivalent shares in the future. The short seller immediately sells the borrowed shares at the current market price. If the price drops, they buy back shares at the lower price to return to the lender, keeping the price difference as profit.
What Are the Risks of Short Selling?
The main risk is that instead of declining, the stock price rises significantly, forcing the short seller to buy the stock back at a higher price and take a loss. Losses can be unlimited if the stock keeps rising before the short position is closed.
What Is a Short Squeeze?
A short squeeze occurs when the price of a heavily shorted stock rises, causing short sellers to scramble to buy back shares in an effort to cover their losses. That scramble to buy back the stock causes the price to quickly rise even higher, increasing losses for short sellers.
The Bottom Line
When exercised responsibly, short selling can actually enhance pricing and improve market efficiency by incorporating negative and contrarian views. Empirical research demonstrates this and also shows how short selling bans have backfired. However, when taken to an extreme, shorting can potentially be abused to unfairly target and sabotage companies. Appropriate restrictions that allow short selling while curbing manipulation appear optimal for maintaining functional markets.
