I still remember the first time I heard about short selling stocks. I knew all about buying stocks. And I knew that after you bought them you could sell them. But it never occurred to me that you could sell them BEFORE you bought them!
The concept took a little while to get my head around.
As I discussed this new (to me) concept with other investors and traders, I soon discovered that many people feared short selling stocks and the idea made some people mad as they accused anyone who would short a stock as “un-American” because they are “betting against American business.”
For some reason, shorting never bothered me. It didn’t feel scarey and it didn’t strike me as unpatriot. On the contrary it made perfect sense that people should be able to participate in the market whether it is going up or down. To only be able to invest to the upside seemed rather limiting and naive … but I was certainly in the minority in that opinion.
First let’s address the issue of what short selling stock actually is. It can be very confusing to someone new to the markets who have been taught to buy low and sell high.
Actually, shorting the market is still buying low and selling high. It’s just doing it in the reverse order: First sell high, then buy back low!
But the mystifying aspect to most is: How can you sell before you buy?
Actually what you would normally be doing is borrowing the stock (since you didn’t buy it first), then selling it so you you can buy it back later at a lower price (and then return the shares to the lender). There is also a fee for this “borrowing.”
While that may sound complicated, it’s a fairly simple process with many brokers and can be executed with the simple press of a button (assuming you have meet all the requirements of your broker and the stock is available for shorting).
You can also short Futures which have been historically more friendly to short sellers than the stock market.
One objection is that shorting is more risky than buying because if you buy a stock your risk is limited to the stock going down to zero. But if you short, there is no limit how high the stock can go against your position.
So, is short selling stock really evil?
Does it hurt the stock market?
Does it do damage to American business and our economy?
This is a perennial topic that seems to pop its head up most commonly during bear markets (for obvious reasons). And so as Washington is attempting to “clean up Wall Street,” the topic is back on the table in D.C. again.
One topic on the table: Restore the “uptick rule.” This rule was introduced during the Great Depression and required that a person could only short a stock if it moved up a tick before you shorted it. The intent was to curtail “bear raids” which could send the market crashing down. However at the time, the stock market moved in fractions. Now it moves in pennies and so the uptick rule has less effect as a move up or down by a penny is inconsequential.
It was only last September when the SEC attempted to curtail the bear market by such a policy. But they didn’t simply re institute the uptick rule, they actually implemented a temporary ban on the shorting of hundreds of financial stocks.
Did it work?
Look at where the market was in September 2008 and you’ll see that it wasn’t too successful at holding the market from going down further. Whether it saved some of those financial institutions from going out of business may be another question.
Sometimes investors get overly excited and pump up markets beyond their true value. We’ve seen this with real estate, financial institutions, technology and even tulips!
While it is good to maintain some balance, and it is certainly possible for the market to go to extremes up or down, short sellers provide a valid role in the markets by helping to apply pressure against the infamous “irrational enthusiasm” we’ve experienced in various markets over the years. And if they don’t prevent it, at least they play a role in bringing markets back to their fair value eventually.
That’s my opinion.
What’s yours?
Leave your comments below.
I feel better now because I too was confused about short selling. I’ve never done it but I have not ruled it out.
Of course its a good thing, what goes up must come down, why not make some money in the process.
Thanks for the freebee Barry!
G’day Dr Barry,
Historically, as you point out, every time short selling has been banned or the uptick rule enforced, the markets have in fact fallen.
This does certainly beg the question as to the validity of the rule.
I do note however, that there tends to be a “popular” backlash during these times of market falls with some quite strong antagonism against “dirty Shorters” popping up in stock market forums.
‘Tis interesting though that the detractors go quiet when one points out that if in a “Long Only” strategy, any sell is the equivalent, meaning a person against shorting should never sell, and also anyone with a long only strategy who sells to buy back at a lower price is effectively doing the same as “Naked Shorting” except they actually own the stock rather than borrowing it. the effect is the same though.
Appreciate your blog.
Joe
The only time i have a problem with short selling is when i am invested in shares of a company. My buying puts upward pressure on the market prices which is what i want. If my broker then collects a commision by lending my shares out to a third party who sells them there’s a conflict with my intentions.
Brokers which offer the lowest commision rates are the most likely to do this so read the fine print. Here in australia we had a broker go bust recently where the fine print said that the people buying the shares didn’t actually own them. The low commision rates didn’t lessen the pain for OPES clients when they went bust.
steve
Reinstating the uptick rule will be virtually useless in preventing short positions unless the restrictions include banning all forms of short selling.
The environment has changed significantly since the last time we actually had an uptick rule in place:
1. Decimalization of stock prices have made markets more efficient with the concurrent ability to get an uptick for only .01 price improvement (vs. 0.125 price improvement under fractional pricing).
2. You can get short by selling calls, buying puts, or selling single stock futures.
3. You can get short by buying inverse ETF’s (like SH).
The above being said – I believe disallowing short positions is harmful to the market in general as it makes the markets less efficient overall.
To the average investor it doesn’t matter if a stock went down because a short seller shorted it or because it was simply overinflated due to a lack of sellers willing (or able) to enter the market.
It basically comes down to whether you believe the process of price discovery is better served by allowing all participants to express their opinion or by attempting to keep a segment of the market from participating.
On a humorous (and skeptically sarcastic) note, I have noticed that only a few months ago the government was blaming speculators for high oil prices. Since oil prices have come down so precipitously recently, shouldn’t we be thanking short sellers of commodities for helping boost the economic recovery?
John
I agree with your comments on short selling and I think the game in DC is just standard politics to make it look like they are doing something and that they know what they are doing. I suspect the average politician does not know the difference between short selling and naked short selling. Naked short selling is the mechanism used for causing real damage to businesses. Naked short selling is illegal and all politicians need to do is encourage the SEC to enforce their own rules. That would be the patriotic thing to do.
Short sellers are the only ones paying taxes this year. They help america to build roads and bridges. They also help pay teachers police and firemen. They help pay for our service people abroad. Short sellers keep money in the system and keep america strong.
Providing they limit the use of naked short selling and somehow protect the little guy from being inundated by the gigantic Hedge funds there may be a reason to short. My experience is that in a completely free market the guy with the most money wins in the short run. When you short a stock it immediately is driven up by the short speculators and when you buy the opposite occurs. The guys with the most money have a distinct advantage.
Ever wonder what the common big picture is on ALL speculative marke climaxes?
I had a theory that the U.S economy has basically been bubble hopping since it’s inception. Recovery times vary and lenght and size of bubbles vary but there is a common trait besides the nebulous investor entheusiasm.
it’s the expansion.. often rapid expansion of money. usualy through credit. This goes back to Tulips and beyond. At the height of tulip mania they wre circumnavigating money creatin laws by creating personal credit notes. the futures market was created inadvertantly also. The height of the Tulip mania so people paying for tulips that didn’t exist in money that didn’t exist.
Most other market crashes that I’ve looked into share this trait. They start from a legitimate market move that is fundamentaly valid and investors start to pile in and rationalize incredibly new heights. This is common to all speculator literature and seems to be true.
what is less common in the “trading books” is the attention paid to expanding money and credit.
Just thougth it was interesting and wanted to share it.
I just wish they leave FNM and FRE alone. geez
If I borrow your car and sell it, It’s called fraud, even if I buy it back and return it. Would you voluntarily loan your stock to someone so they can drive the price down? The main source of shorting equities is market makers and stock specialists, they sell to the suckers at the top, and buy it back at the bottom, that is their purpose, it is called making a market. You have given these firms the ability to drive your economy into the dirt. So in this case we have exchange rules supercedeing our property laws, and market maker program terms supercedeing exchange rules, it’s the American method of funneling the funds of the many into the hands of the few.
Short selling will always be a hot topic, however; price ultimately ends up being right regardless of which side that your on and an often overlooked fact is that short sellers often put support under a down trending stock, because they eventually have to become “buyers”.
What a brilliant lot of comments! nice discussion.
A couple of other points I’d like to make re the banning of naked shorts (I’m from Australia, so we can still do it here, barring financial stocks at the moment, and as someone above has pointed out, puts are still available).
Firstly, the car analogy is cool, except, i am not actually driving around or otherwise using the scrip that might be my stock holdings, so a slightly off kilter example. Perhaps a savings account is closer where one “keeps” one’s hard earned, actaully enabling a bank to loan said money out (for a fee, the Interest you earn on the deposit) so they can make a further buck while you are not using your money. All which is above board and legal.
Secondly, truth be known, and this IS a contentious issue, i would like to see the banning of “Naked Long Buying”…
What is that may you ask? The idea of BORROWING someone else’s money, to buy something, with the expectation that you can then sell that something, and make a profit.
Think Margin loans, leveraged instruments, or even outright borrowing to purchase shares.
This is as heinous as some beleive “naked short selling.
it creates inflation, bubbles such as our recent stock market bubble, credit crisis, expands the monetary supply (inflation again) and basically pushes out the little fellow, who only uses “real Money” that they own from being able to purchase.
Unfortunately, I’ve never heard anyone get upset by this practice in the same manner as they get upset by naked shorting.
Joe
Good comments. I like the one about the those nasty short sellers driving down the price of oil. LOL.
Regrarding the assumption that is is fraud for someone to borrow your shares to short. If you have a margin account, you have agreed to this practice and will get no compensation while the broker gets interest and commission. Read the fine print in the margin agreement. If you are a long term investor and this is an issue for you, then open a cash account.
Naked long buying – hmm. Does that mean that someone else can double the amount of naked short selling? Or do the naked shorts and naked longs simply cancel each other out? Confusing.
There is some truth to the point that a short seller is hoping that the company does poorly or goes out of business. But you have to also remember that the company is going south because of poor decisions and not just because some people have gone short. The employees will lose their jobs regardless of whether I am long or short or have no position. Enron, Fannie Mae, and AIG did not collapse because of short sellers.
Short selling of stocks is different than that of commodities. In the case of commodities the additional liquidity and risk transfer ultimately benefits the producer and the consumer. With stocks there is no product except an organization that makes money. These are peoples lives at stake and at times all organizations go through money loosing periods, so to a degree we should want our stock market to allow time for pause and introspection.
Commodities also always have some value, stocks can go to zero value simply based on the confidence of the market. So to a degree if we allow traders to create crisis in confidence we create opportunity for traders to destroy the very thing they are trading.
Naked Short selling can be destructive to companies. Think about it a bit. Through an accounting gimmick naked short sellers create an economic hammer larger than the company itself. While it is rational to kill bad companies quickly, there is such a thing as too quickly and too sudden a death. Also a weapon of such magnitude can be misused.
To me these questions are not simple in nature. Therefore the correct approach is to place your trust in the people who are the more powerful quants. In this case the exchanged, and the regulators who each have more power to understand this than you and me. And much more than any politician can understand. Therefore we should rally behind the conclusions of the quants who have studied this issue.
Be careful which securities to short.When holding shorts the seller is responsible for royalties such as dividends to stock holders. Shorting is taking a piece of responsibilty for that company’s liabilities towards that security.
These are some excellent perspectives. From a historical standpoint, has the uptick rule prevented any market crashes? We’ve had several significant downturns in the market since 1934 like the late eighties and the dot com bubble etc. Was the uptick rule helpful then or during any other bears? It would be nice to have some facts to back up the relevance of the uptick rule in preventing any financial system or market crisis in the past.
Hi Dr
i d like to thank you for all the education that you ve given me . you made me a better trader . a trader in control . i dont chase markets anymore i let the market come to me
Dear. Mr Burns.
Thank you for your generosity and providing all this great info. I have incorporated some of your strategies into my trading and have done well.As
always I appeciate your hard work.
Good Trading,
Manny
Hi Barry, Only just seen your Videos and I feel more encouraged. Been Trading 7 years made all the mistakes you can make.I get ahead then give it back
Made a heap on Options and gave it back,I used to wait for “All the Ducks to Line Up” so to speak but I always waited to long. You have given me a new insight.
Thank You
Dr. Burns
Another great video, Thanks for the teaching
tools… They really help.
I follow your weblog for quite a extended time and must tell that your content articles often prove to be of a high value and quality for readers.
Why don’t you discuss the hedge funds of from 3 to 10 TRILLION DOLLARS EACH moving the market as they wish???
Below is just a little information on short selling from my small unique book “The small stock trader”:
Short selling is an advanced stock trading tool with unique risks and rewards. It is primarily a short-term trading strategy of a technical nature, mostly done by small stock traders, market makers, and hedge funds. Most small stock traders mainly use short selling as a short-term speculation tool when they feel the stock price is a bit overvalued. Most long-term short positions are taken by fundamental-oriented long/short equity hedge funds that have identified some major weaknesses in the company. There a few things you should consider before shorting stocks:
• First of all, you want to short stocks when the market sentiment is negative (in the bull market most stocks go up, and in the bear market most stocks go down);
• You should also look for changes, besides an expected profit taking, that may trigger a stock price decline, such as massive insider selling, a lower-than-expected earnings report, profit warning,a dividend cut, etc.
• Beware of short squeezes and takeover bids (small caps are more vurnerable);
• Check the short interest (ratio) and its trend;
• Be quick (stock prices decline several times faster than they rise);
• Cut the losses short and don’t average down your losing short positions to avoid being caught up in a cross fire of a Volkswagen short-squuezelike scenario;
• For longer tern short positions, one of the best candidates to short are the former leaders, big winners, close to the top of the bull market, as these same winners of the last bull market usually fall the hardest in the next bear market. Early–cyclical stocks are also good candidates to short in the beginning of bull/bear markets.
Despite all the mystique and blame surrounding short selling, especially during bear markets, I personally think regular short selling, not naked short selling, has a more positive impact on the stock market, as:
• Short selling leads to better price discovery;
• Short selling increases liquidity, which in turn narrows the bid/ask spreads;
• Short selling may also serve as a hedging tool or a pairs trading tool;
• Short selling provides profit opportunities in bear markets;
• Short sellers are a counterforce against upside-biased insiders, stock analysts, investment bankers, stockbrokers, stock investors, and creditors.
Lastly, small stock traders should not expect to make significant profits by short selling, as even most of the great stock traders (Jesse Livermore, Bernard Baruch, Gerald Loeb, Nicolas Darvas, William O’Neil, and Steven Cohen,) have hardly made significant money from their shorts. it is safe to say that odds are stacked against short sellers. Over the last century or so, Western large caps have returned an annual average of between 8 and 10 percent while the returns of small caps have been slightly higher.
I hope the above little information from my small unique book was a little helpful!
Mika (author of “The small stock trader”)
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