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.

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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.