Thursday, September 18, 2008

The One Minute Case for Stock Shorting

I originally wrote this for the website "The One Minute Case" here. Given that short sellers are once again a scapegoat for a declining stock market, I have decided to re-publish it:

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 volatile. Long investors would have more difficulty buying and 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.

***

9/25/08 clarification:
Added "buying and" to last sentence, third paragraph from bottom. It now reads: "Long investors would have more difficulty buying and selling their positions, and the lack of liquidity would make it more difficult for companies to raise funds in public offerings." For the reason, see my answer to J. Henry's question in the comments below.

18 comments:

Chuck said...

Thanks for that informative post, Ray. I was just watching CNBC and Jim Cramer was discussing short sellers. He defends short sellers, and says they shouldn't be under the regulatory assault that seems to be coming at them.

But he said there is one scenario where the government might have to take emergency measures: if there are financial *terrorists* doing the short selling, solely to bring down the US economy. I assume he means some super rich Saudis? In any case, he said if the government found that that was going on, it might be necessary for some kind of temporary disclosure rules to identify and prosecute them.

Could such a thing as financial terrorism actually work in the marketplace? Or is Cramer just grasping at straws for an explanation of all the plummeting financial stocks?

Galileo Blogs said...

I think Cramer is grasping at straws. According to Reuters, the total market capitalization of the world's stock exchanges in January 2008 was over $50 trillion. I would guess that the U.S. share is anywhere from 1/4 to 1/2 that amount, or $12.5 to $25 trillion.

So how will the financial terrorist successfully destroy this market? He would need a phenomenal amount of money, and that assumes that the market would somehow stop trading after he has exhausted all of his funds. Far from it. Once he had finished shorting the stocks until he had no more money left, other investors using their money would take the bargains and bid the stocks back up.

To take this a bit further, consider that the total gross domestic product for the entire country of Saudi Arabia in 2007 was $565 billion (according to the CIA Factbook). So, even if some Saudi madman could corral the entire output of his country for one year, which means the value of all the oil sold by his country that year, and more, he could only bring to bear funds equal to 2.5%-5% of the value of U.S. stocks.

These numbers demonstrate that there is no way for a "financial terrorist" to harm the stock market through aggressive short selling. There simply is not enough money to even come close to such a goal, even if it were possible.

Cramer may be a good trader, but he is a lousy economist. I've heard him say many other false things on his show. For example, just last night I heard him say that he supports financial regulation, the nationalization of AIG, and further inflation of the money supply. All of these ideas are bad, and will only make the current situation worse over the long run.

He states things so emphatically that people find his views credible. Also, they assume that because he knows stocks well, he also understands economics and broader financial principles. Those are wrong assumptions.

A different explanation of this meltdown is that it is the consequence of years of government inflation of the money supply. That inflation showed up in inflated home values, which the banks lent money on. When house prices fell, as they had to, those mortgages collapsed in value. Anyone who bought them got hammered, thus the wipe-out of Bear Stearns and Lehman Brothers, who bought many of these inflated securities.

Financial crises always happen suddenly and disconcertingly. The pain of their sudden occurrence is why people grasp at anything as a scapegoat. Short sellers and greedy businessmen and immoral Wall Street executives have served as classic scapegoats since the 1800s. Cramer is also ignorant of history.

Chuck said...

Well, that answers my question. I didn't mean to imply I liked Cramer. I don't. I can't stand his bombastic shtick. But it was the first time I had heard that particular explanation.

Galileo Blogs said...

Glad my answer was helpful. As for liking Cramer or not, you're entitled. I think of him as the Donald Trump of stock trading, with all of the good and bad implications of that image. However, that might be overstating it, because I don't *know* how good of a trader he is, whereas I can point at Donald Trump's building triumphs.

softwareNerd said...

Just this morning on Bloomberg, James Grant was pointing out that the new restrictions are bans on free speech, and bans on people who want to act on their own views of reality.

Galileo Blogs said...

I am speechless at the metastasizing scope of government-imposed regulatory cancer on the markets (how do you like that for an analogy?). A ban on short selling is based on complete ignorance of its productive role. It will have adverse consequences.

Of course, you can add into today's news the socialization of risk in money market funds through a government guarantee against losses. That's on top of the nationalization of AIG earlier this week, and on and on.

In many ways, this is the 1930s redux (although that era was still worse). Guess who is going to get blamed? It's Bush's "free market" policies. Incidentally, that blame is one good argument to vote Democrat this election. Bush is this era's Herbert Hoover. Like Hoover, he was a vigorous interventionist, and helped cause the crisis that later on got blamed on "capitalism."

Valda Redfern said...

"Short sellers bring to light valuable information about poorly run companies." I am particularly glad you emphasised this point in your illuminating post. I have an interest in (software) measurement and know that the best way to minimise damage from errors and inefficient practices is to get the bad news early.

Anonymous said...

Thanks for the succinct and informative explanation. What about "naked" short selling? Could you please comment on that? Thanks.

Galileo Blogs said...

Valda,
How true! If only everyone sought to get the bad news out early. Many problems, including our Wall Street meltdown, stem from trying to avoid bad news. That's how I see the government's $500 billion - $1 trillion infusion into the markets this past week. By extending more credit, the bad news of poor financial decisions regarding mortgage lending will be mitigated and delayed.

Such delay or "papering over" the problem will allow new problems to fester without knowledge of their existence, setting the stage for future meltdowns. More numerous and dramatic meltdowns will happen when the government papers over bad news.

***

Anonymous,
I don't have a particular view on naked short selling, which is selling a stock short without borrowing it first. Naked short selling stocks seems similar to everyday practice in commodity markets. Commodities are sold short in a similar manner in the financial markets everyday. It works just fine.

If there weren't problems with the balance sheets of financial companies to begin with, shorts could not make money on their stocks, whether they sold short naked or in the traditional manner. The real problem is the precarious financial state of the banks, brought on at the most fundamental level by years of government-sponsored inflation that induced the banks to make unwise mortgage loans, and then deal in precarious mortgage-backed securities.

Having said that, it is possible that naked shorting could make the markets too volatile by making it too easy to short stocks. However, whether that is true and requires corrective action is properly a contractual matter to be decided by the stock exchanges and their customers. It should not be an issue for the government to decide.

All permissible trading practices should be set strictly privately, without governmental interference. The SEC has no right to make pronouncements in this area or dictate rules. If private traders violate private contracts that specify what type of trading is permitted, the courts can handle the situation.

Christopher Cox (head of the SEC) has no right to dictate terms to traders and the exchanges they operate under. Moreover, because he is not the best informed or best motivated to make the best decisions, whatever he does will be harmful. At the very least, his multiplying arbitrary actions will introduce unnecessary chaos and uncertainty into the financial markets.

By the way, exchanges today routinely set terms of trade for their trading customers. For example, the NYMEX (New York Mercantile Exchange) where commodities such as oil and natural gas are traded, routinely sets terms such as collateral limits, order sizes, minimum creditworthiness levels to trade, etc. That is how it should be.

Thank you for your questions.

Anonymous said...

How could you sell a stock short if you haven't borrowed it first? Wouldn't that mean that you didn't own it and therefore you were selling something you didn't own? Isn't that fraud by definition? I'm all for short selling but it shouldn't be fraudulent.

John Kim

Galileo Blogs said...

John,
It's not fraudulent if it does not violate exchange rules. I also refer you to my comment immediately preceding your question. My main point is that this should be a private contractual matter between exchanges and their trading customers. If traders violate contractual terms, the proper redress is the courts. There should be no *regulations* in this area.

Also, as I elaborate in my comment, short selling, whether naked or not, cannot drive a stock down if the company is sound. That is why the governmental attacks against short sellers (naked or not) is simply scapegoating Wall Street traders for the current crisis.

Elisheva Hannah Levin said...

Thank you so much for your clear and concise explanation. I did not know what short selling was and you have cleared that up for me.

Another question: Is short selling related to margining your stocks? When we were buying a house, my husband margined some of his stocks.

Thanks again!

J. Henry said...

Galileo,

Yes, thank you for the post. It answered many questions I have had.

Forgive my ignorance of how the stock market works, I am trying to clarify some things in my mind:

You wrote, "By taking financial capital away from poorly run companies, short sellers free up money that can go to the best-run companies." Is the primary reason that a company cares about the value of the stocks, stocks which it has already issued and sold, because they may want to issue more stocks in the future?

You wrote,"Without short sellers, markets would be less liquid and more volatile. 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." Would markets be less liquid because long investors wouldn't be willing to take their capital out of a company without the negative information that a short-seller brings to light? Why would a long investor have more difficulty selling their position without short-sellers?

Galileo Blogs said...

Elisheva,
When you margin your stocks, you are borrowing money using your stocks as collateral. Margin is simply a loan.

Shorting is different; it is a bet that the price of the stock will decline.

Galileo Blogs said...

J. Henry,

Those are good questions. Here are my answers:

(1) The short answer is: yes. A company cares about its stock price because it will greatly bear on how much money it can raise when it issues stock in the future. In addition to large, infrequent public offerings of stock, many companies also issue stock continuously through dividend reinvestment programs. A high stock price directly influences how much capital a company raises in this manner.

Many companies compensate their employees through stock and stock options. A high stock price makes this form of compensation more attractive.

A company also uses stock to acquire other companies. Again, a high stock price makes it possible to do more, larger acquisitions.

Conversely, a company with a low stock price will suffer many ill effects:

It might get taken over, and senior management will lose their jobs.

It could lose employees who are compensated in stock.

Its customers and suppliers may stop doing business with the company out of fear that it may go bankrupt. (Observe how this happened with Bear Stearns and Lehman.)

Credit rating agencies may downgrade its debt based on a low stock price as an indicator of underlying company problems. That will make it more difficult and costly for the company to obtain new loans or renew existing loans.

In general, a high stock price helps a company function at its highest level, and a low stock price hurts the company. Of course, stating it this way reverses cause and effect, which primarily works in the other direction. A well-run company will tend to have a high stock price, just as a poorly-run company will tend to have a low price.

(2)You ask, "Would markets be less liquid because long investors wouldn't be willing to take their capital out of a company without the negative information that a short-seller brings to light? Why would a long investor have more difficulty selling their position without short-sellers?"

There are a lot of ways short-sellers bring liquidity to the market. First, they stand as ready sellers of stock. That frees up stock for long investors to buy. At the same time, by necessity they also stand as ready buyers of stock. When they sell borrowed stock to initiate their short, at some point in the future, they must buy it back to "cover" the short. That buying demand makes it easier for holders of stock to sell their positions.

So, short sellers provide liquidity on both the sell and buy sides. (I should amend my statement to make that clear; both selling and buying is aided by short sellers.)

Short sellers also enhance liquidity by causing capital to leave poorly run companies. That increases the liquidity (i.e., cash) available to buy securities of well-run companies. If the short-sellers did not exist as active agents ferreting out information and bringing it to light about poorly-run companies, capital would be needlessly "trapped" in the shares of poorly run companies.

In concrete terms, the more shorting that goes on, the more capital there will be to bid the prices of well-run companies even higher.

Galileo Blogs said...

My last paragraph above points up the important *moral* role of what short sellers do. They are the financial sheriffs in the market. They "punish" poorly run companies by taking away their capital. This makes it easier for other market speculators and investors to reward the good guys. (Of course, they don't literally function as sheriffs. Everything they do is the result of voluntary transactions with willing counterparties, unlike a sheriff who uses force.)

Incidentally, I forgot one other important way in which short sellers provide liquidity to the market. Short selling is an important method of hedging the investment risk of taking a long position in a stock. For example, one way of protecting a long position against a decline in value is by shorting a similar stock. This is called "pairs trading." If you ban short selling, you also foreclose long positions taken as part of pairs trading. That will reduce liquidity available for long positions, which is certainly not the avowed intent of the ban on shorting.

J. Henry said...

That was immensely helpful, Galileo, thank you!

Anthony said...

"Naked short selling stocks seems similar to everyday practice in commodity markets. Commodities are sold short in a similar manner in the financial markets everyday. It works just fine."

That's a futures market, which is completely different, because it's a promise to buy/sell something in the future, not to buy/sell something now.

There's no restriction against entering into a "naked short" of a stock in the single stock futures market.

Alternatively, think about it this way. "The short seller pays a fee to the owner to borrow his shares." If naked shorting were allowed, why would anyone ever borrow shares and pay a fee to the owner?

What does that fee cover? It covers the default risk. It covers the loss of voting rights. And it covers the negative tax consequences of payments in lieu compared to qualified dividends.