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The Naked Truth on Short-Selling

The Naked Truth on Short-Selling

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Friday, 16 December 2011 06:36

For some reason short-selling has a bad reputation in many circles. It is often blamed for bad things happening to good companies and/or good countries. The story among short-sellings critics is that it involves market manipulation, where big actors are attempting to profit by sending stocks or bonds plummeting.

Floyd Norris has a good column on short-selling in today's NYT. It sums up research on the issue which indicates that most of the time when companies are complaining about short-sellers, the shorters are actually identifying over-valued stocks and in some cases uncovering fraud.This certainly seems to have been true of the short-sellers who were attacked Fannie Mae and Freddie Mac before they were put into conservatorship or Lehman, Citigroup and other badly troubled banks in the heyday of the financial crisis.

Certainly there are instances where shorting is in fact market manipulation, but there are also instances where traders take long positions to manipulate the market. (The notion of market manipulation here is using your trading to deliberately drive stock prices in the hope of being able to profit from the movement you have created. In the case of shorting, you hope to send the stock price plummeting and then buy back shares at a big discount. On the long side, the hope is to create a euphoria around the stock and then dump it before people realize that the price has no basis in the fundamentals.) There is no intrinsic reason that short trades will be more susceptible to manipulation than long trades, except that most small investors (who lack the ability to move markets) can't do shorts.

Short-trading, when it is based on fundamentals, can be seen as equivalent to exposing counterfeit money. It is showing the public that a company is not as profitable as widely believed. It would have been hugely beneficial to the economy if we had many people shorrting Lehman, Citigroup and the other companies pushing and securitizing subprime mortgages back in 2004.

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Lehman, Citigroup and the other companies
written by JSeydl, December 16, 2011 6:21 AM

It would have been hugely beneficial to the economy if we had many people shorrting Lehman, Citigroup and the other companies pushing and securitizing subprime mortgages back in 2004.

That is hilarious.

+0

...
written by Ron Alley, December 16, 2011 7:15 AM

Although short selling is not, in itself, market manipulation, short selling is an essential element of almost every market manipulation scheme. Short selling in the hands of a market manipulator is like a gun in the hands of mobster. We need effective regulation of both guns and short selling.

-2

Short selling and Market manipulation
written by Dean, December 16, 2011 8:32 AM

Ron,

actually many manipulation schemes are entirely long. You have a small company, you spread stories about its great prospects, which are supported by buying large numbers of shares. This generates a buzz that propels the stock higher and then you dump. I believe that folks connected with Boston Chicken had a scam like this going. It's not rare.

+4

...
written by skeptonomist, December 16, 2011 8:59 AM

Short selling is another thing that market operators can use to take money out of the economy without any real benefit to it. Every market trick can be justified in some way, and ideally short selling can be beneficial, but in practice it must be tightly regulated. Insider information can be more useful for short-selling than long buying and it is very obvious that regulations are not sufficient, as shown by the ability of Goldman Sachs to short-sell the mortgage bundles it put together and which it knew were garbage. Are the short/long manipulations of "hedge" funds really beneficial to the economy?

To leave the detection of fraud to the market by short selling or any other means is complete foolishness. In some cases those who have destroyed companies have been able to take advantage of it through short-selling. Yes, when insiders start selling short it is an indication that something is wrong, but only if this particular short-selling is known.

+1

Short selling does not require inside knowledge
written by Dean, December 16, 2011 9:34 AM

Skeptonomist,

I am at a loss to understand the asymmetry to see between short selling and long buying. If I had the means, the I would have shorted housing and bank stocks in 2004-2007. I wasn't able to do this because you typically need large amounts of money to cover a short sale. However, this transaction would have conveyed information to the market. It had nothing to do with insider knowledge, it simply involved using arithmetic that most investors apparently don't understand.

+3

Short-Selling is Good
written by Callaway, December 16, 2011 9:49 AM

Having naked short sellers in the market also provides liquidity.

+0

Stocks shouldn't be casino bets
written by downpuppy, December 16, 2011 9:55 AM

A hyping scheme only hurts the people who buy into it. A successful bear raid can destroy a company, employees and shareholders.

+0

Hyping Schemes Hurt Everyone
written by Dean, December 16, 2011 10:21 AM

A hyped stock is pulling capital away from productive uses. If an economy is near full employment (the good old days), it is a drag on the economy in the same way as a government department of waste, fraud and abuse. It is very far from harmless.

+4

Paulson
written by joe, December 16, 2011 11:27 AM

Is Dean not aware that Hank Paulson tipped of a dozen hedge fund managers that Fannie and Freddie were going into conservatorship?

+1

...
written by fuller schmidt, December 16, 2011 1:05 PM

Traders correct over- and under- valued prices. Had the market exposed the sub-prime mortgage mess sooner. pension funds, etc. would not have taken the huge hits they did. Efficiently priced markets are your friend.

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Your Friends
written by KeithOK, December 16, 2011 1:56 PM

Efficiently priced markets are your friend

As are unicorns and leprechauns.

+1

...
written by Jeff Z, December 16, 2011 2:06 PM

Efficiently priced markets are your friend.

True enough, but what does an efficient market really mean? One meaning is that the 'market' as a collective entity processes all of the information available to it because all the individual traders are acting on their own bits and pieces which they believe to be accurate. This is a very Austrian school way of thinking about this.

But traders can be bamboozled. If nobody has accurate information, or nobody else can pick out those that have accurate information, every trader reacts to every other trader as if they are privy to some slice of the informational pie that they themselves lack. And the reverse. Voila - efficient markets! No individual has all the information, only the 'market' has it all. But the market does not instantly correctly price assets, partially because of genuine uncertainty. Will Facebook be worth anything in a decade, or will it go the way of Pets.com?

A truly efficient market in the sense of correctly pricing all securities can not possibly exist on earth. The collective knowledge of all market participants is still limited, still prone to bias, still prone to bouts of optimism and pessimism of gargantuan proportions. And still prone to randomness, which itself causes reactions.

Since it takes a bigger stake to manipulate short than long, this is another reason why these markets can be said to favor bigger players at the expense of the small investor/saver. And thus why they need to be stringently regulated, for starters.

+2

Short selling is not out of reach for small investors
written by AndrewDover, December 16, 2011 2:55 PM

"I wasn't able to do this because you typically need large amounts of money to cover a short sale."

I doubt you actually tried, because when you sell the stock, you get the money at the begining of the trade.

The main barrier to short selling is lack of familiarity. A trade has two activities, a buy and a sale. A short sale just has the sale occur before the purchase.

Warning: If you buy a stock for $100, the most you can lose is $100. If you sell Apple short at $380, and Apple jumps to $980 you could lose $600.

You could also buy a mutual fund who shorts stocks like prudent bear

http://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1324068632139&chddm=648608&q=MUTF:BEARX&

+1

To: Keith the humorist, Jeff and Andrew the theorists
written by fuller schmidt, December 16, 2011 6:26 PM

There are many recent examples of crony capitalists being slaughtered by shorts; subprime mortgages, Asian Tigers, Greece and co. That's good for you whether you realize it or not. Also not often realized, democracy can't exist without a market economy.

All investing has risk, once again whether you realize it or not. Dangerous overbought and oversold conditions are identified, and risks are taken by traders, with beneficial results, as above.

Lastly to make trading worthwhile you have to have substantial margin money in your account for short sales as well to buy.

+1

Short covering
written by Dean, December 16, 2011 10:07 PM

Andrew,

I was talking about exactly the situation you were describing. If you short a 100 shares of a stock at 100, and the price rises to 150, then you have to be able to put up $5k to cover the potential loss. Most small investors are not prepared to have any substantial pool of money quickly available.

+2

...
written by Jim A, December 17, 2011 8:43 AM

Well it IS somewhat easier for an outsider to spread rumors which will temporarily lower stock price than to spread rumors which will temporarly raise it. Of course at some level that can be regarded as evidence that the market is more afraid that stocks are overvalued than hopeful that they are undervalued.

+0

Yes, a small investor can only make small investments, be they long or short positions.
written by AndrewDover, December 17, 2011 3:29 PM

Dean,

You can simply place a purchase order at a higher price to eliminate the possibility of unlimited losses. For example, your small investor would have $10,000 at risk if they bought 100 shares at $100. If they sold short 100 shares at $100, with a stop-loss buy at $200, they also would have a maximum of $10,000 at risk.

+0

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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