Is short selling bad for the market?

TK All-Star posted on 04/02/09 at 11:30 AM

Nicole Wachs explains why short sellers play a vital role in keeping markets moving.

Last time I covered a few basic points about selling short and some of the operational pitfalls you may encounter along the way. As a quick review, short selling is the process of borrowing shares from your broker and then selling them in the open market without ever owning the shares. Your goal is to purchase the shares back for less cost in the future and net a profit. If the cost increases, you will net a loss -- and, in fact, short selling can result in unlimited losses. In other words, proceed with extreme caution.

For today’s post, I’ll explore how individual short sellers impact the broader market. I’ll also discuss what happens when short sellers think it’s time to bail on their positions. The next post will cover some key indicators short sellers use to help them make trading decisions.

Does short selling help or hurt the bigger market?

Short selling’s reputation isn’t helped by the shady-sounding nature of the transaction. It’s further hampered by the belief that short sellers somehow cause market stampedes downward. After all, you only hear a lot about short sellers in the news when markets are bad and getting worse. Here are a few ways short sellers keep market healthy and humming.

Short sellers provide liquidity at times when the market badly needs it. Consider a classic buying frenzy: everybody’s clamoring to buy stock XYZ. Ultimately there’s a finite number of XYZ shares out there – that’s called the float. If investors just keep wanting to buy, buy, buy, you’ll run out of shares eventually and the price will sky-rocket. Somebody’s got to step in and sell, and if none of the longs (the stockholders) want to, a short seller is your supplier.

Short sellers express a contrary opinion: markets are headed south. If the market’s beauty is how clashing opinions meet and get settled in a public sphere, short sellers have an important role in that dialogue.

Investors have a natural bias towards going long, towards owning an investment that will grow and yield profits over time. Short sellers run counter to that bias, and while it’s not always popular, it’s a brave, sometimes necessary opinion to voice. As we’ve seen lately, overbought markets are highly unhealthy; short sellers serve a valuable, if unpopular, purpose in expressing their contrarian opinion. It keeps the bigger system in balance. Because short selling goes counter to the natural long bias of the market, it’s an essential part of the price discovery mechanism.

Short sellers must cover their responsibilities. While it may sound dishonest to sell something you do not own, as if you’re stealing, the fact is that short sellers have initiated a financial obligation when shorting, and later must make good on it. They will need to buy the shares – a.k.a “cover” – at some point.

Buying and selling go hand in hand. As I said earlier, it’s common for people to buy first, sell later. Short sellers just do it in reverse order. So when short sellers decide it’s time to cover / buy, the result can be a dramatic bullish move. This is referred to as “short covering”, “covering shorts”, “a short-sell bounce” , or my favorite term, “a short-squeeze.”

The short squeeze – shorts are not immune to Mr. Market.

Because of this financial obligation, short sellers must react accordingly if the market moves against them. If short sellers are wrong and prices climb, they’re in for a world of hurt. If you sold XYZ shares for 50 and you’re short, then XYZ climbs to 60, 70, 80, you’re still on the hook to buy back those shares.

There are three main reasons which cause short sellers to run for the exits and cover their positions. First, managing losses and risk is the same as it is for traditional buy and hold investors. The need to keep losses low causes short sellers to buy if the stock is moving higher against them.

Another reason for shorts to cover is because they may not have enough capital to maintain a now higher margin requirement for the short position. We talked about margin requirements in my last post. If they cannot come up with the cash, the position will be closed, either by the trader or by the brokerage firm.

There is one more main reason which causes a flurry of buying activity from shorts – the threat of a “buy-in.” When prices are rising, the longs are more likely interested in taking profits – selling long. In order to do this, the stock must be able to be delivered to the new buyer. If too many people have shorted the stock, it may be possible that there are few shares for the long seller to deliver to the new long buyer. As I said last time, the actions of the long investor are not hampered by those of the short seller if shares were borrowed. If there is a shortage of shares for delivery, traders with short positions may be notified of a potential “buy-in.” This is when the brokerage firm decides to buy back shares held by short sellers in order to allow long sellers to deliver shares to the new buyers. As you can see, if prices are rising, the chance of this happening becomes more and more likely. Since most people don’t like being told what to do, short sellers who receive a warning about a possible buy-in usually decide to take matters into their own hands. They feel they will be more skillful at closing the position at a better price than the brokerage firm might get.

All of these factors cause the short seller to close out. Remember in this case closing the position means buying. And these three factors have a cumulative effect. They build upon each other, which may in turn cause more short covering and will likely attract long buyers too – “never another down day on Wall Street” as the saying goes. This can result in panic buying – a lot of it – and may be referred to as a “floor” in a particular security or even the market in general. As you can see, you can easily get crushed if you’re not on top of a short sale when it’s moving against you.

Rallies driven by short covering aren’t necessarily sustainable, but nonetheless they can be powerful. They are also a sign that short sellers aren’t getting away with any fast moves. It remains to be seen if the recent upward bounce we’ve seen was just a lot of shorts covering or based on other, more sustainable factors. Short sellers alone don’t have the power to change a market trend, but they can be useful harbingers of an overbought market turning a corner.

Short-selling: as American as apple pie

Free speech, an independent spirit, and free markets are key American virtues – and ones that, believe it or not, short sellers exercise every day. They’re a necessary part of the financial markets and are here to stay.

Bring me your questions. I’m happy to explain more aspects of short selling or discuss your views on the subject.

Next time we’ll dig into a few other aspects including “short interest” and “days to cover”. Until then!


Regards,
--Nicole Wachs
Director of Education
All-Star Commentator

Nicole’s previous blog posts: Just how evil is short selling? and GS751 Plays the Smart Skeptic

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Share this! Report

Posted by TK All-Star on 04/02/09 at 11:30 AM

Comments

pretzel posted April 05, 2009 (05:38PM)

I don't have anything against short-sellers.  For one thing, more and more I invest for dividends or potential dividends for income which mostly negates share price.

However I respectfully disagree with point #2 above.  Short selling may make a stock more "liquid", but I think it's artificial liquidity, and they are selling shares that really aren't theirs.  In a normal supply-demand situation, the buyer would either have to just pay the higher price or forget about it.  Is there anything wrong with that if the holder doesn't really want to sell their shares right then?  Is a lot of liquidity "needed" really?

NicoleWachs posted April 13, 2009 (12:10PM)

Hi Pretzel,
Thanks for posting your views and comments. Your concerns will be covered in my next post and will be published later this week.
Thanks again,
Nicole Wachs
Director of Education

You must Log In to post to this blog.

Not a member? Register Now to …

  • See what other traders are doing
  • Make your own trades public
  • Share your thoughts on a trade
  • Join or start a group
  • Connect with like-minded traders