I have observed a lot of discussion of short sellers in the capital markets on DKos in recent weeks. As stocks have fallen and 401(k)s have partially evaporated, short sellers have been blamed for exacerbating the crisis by betting "against the line", driving stocks down, and making money from other people's misery.
The result has been discussions of banning short selling, reinstating the "uptick rule", and similar misguided ideas. This diary is here to help address misconceptions and argue that short sellers are necessary components of the process who likely mitigated aspects of the crisis instead of exacerbated it. [Note that this diary does not apply to "naked short selling", a different phenomenon that actually is destabilizing).
Stay with me through the carnage.
What is a short sale?
First of all, let's discuss what a short sale is and how it works. Normally, when you buy stock, you give money to the seller in exchange for title to the stock. While you hold the stock, any dividends the stock pays are yours to keep. When you decide to sell the stock, if the price is higher than your buy price, you make money. If the price is lower than the buy price, you lose money.
In a short sale, the opposite process occurs. The short seller borrows the stock from an owner, then sells the stock on the open market. While the short position is open, the short seller must pay the stock's dividends to the actual owner out of his own pocket (also, the short seller must pay the actual owner interest). To close the position, the short seller must buy the stock back on the open market, then give it back to the actual owner. If the stock falls, the short seller makes money since he sold the stock at a certain price but must buy it back at a lower price. If the stock goes up, he loses money.
Short selling is structurally risky
When you buy a stock, the theoretical possibility exists that you can lose all your invested money, however the possible gains are infinite. If Citi is trading at $2, the most you can lose is $2 per share if you own Citi stock, but if Citi goes to $100, you make $98 per share!
Short selling is the exact inverse. In short selling, the maximum gain you can ever make is the stock price; however you are on the hook for potentially infinite losses if the trade goes against you. In the above example, shorting Citi at $2 means you can only ever make $2/share if Citi goes completely BK. However, if Citi goes to $100, you lose $98 per share!
In reality, of course, your brokerage will not allow you to run up infinite losses. When you short sell a stock, you are required to keep a certain amount of cash in your account to cover possible losses (so, just as it requires that you tie up cash to buy stock, so too must you tie it up to short). This reserve cash is called your "margin". Stock brokerages and the SEC have rules about how much of a margin you are required to keep. If your margin becomes too small because the stock you are shorting has risen too far, you get a "margin call", a demand by your brokerage to deposit more cash into your account. If you fail to do so, the brokerage forcibly and without your permission liquidates your position by buying the stock and closing your short position. (The brokerage doesn't want to be stuck with your infinite losses).
This margin requirement creates odd market phenomena such as the "short covering rally", a temporary positive feedback loop in which a rise in the stock price forces a short seller to buy stock to close a position. This buy pressure forces the price of the stock up, which puts another set of short sellers in a marginal position and forces them to liquidate as well, creating a whole new set of buy orders, etc. This kind of effect can create a whipsaw effect where the market rockets upwards very suddenly, bankrupting legions of short sellers (note the almost 1000 point rise in a single day in the midst of a horrible bear market back toward the end of last year).
To summarize:
- When you buy, you have limited risk but infinite profit potential. Short sellers have limited profit potential but unlimited risk.
- Short sellers are prone to being wiped out by volatile market movements. A stock owner can merely hold the stock for an infinite time if the trade goes against them temporarily (putting aside whether this is a good idea or not). A short seller can be crushed in a short time and forced to liquidate their position.
Short sellers provide market liquidity and decrease, rather than increase volatility
When we say "liquidity", all we mean is that it is easy to buy or to sell a stock when you want to do so. Illiquid stocks have issues such as wide bid/ask spreads, in which sellers and buyers are too far apart on price for any deal to be made. This situation creates an inefficient market and uncertainty since no one can ever be sure what a stock can be sold for. What this situation translates into is volatility.
For example, lets say a bunch of people are holding Citi stock. If there are no buyers for Citi stock, that stock is essentially worth zero (can't sell it). But let us say that Citi stock is plummeting in price and everyone is afraid to buy it. Transactions are few and far between, since they need both a willing buyer and a willing seller. How low will it go? No one wants to get near it! This type of thing happened often in the time when the SEC banned short sales of financial companies (and we got some of the sharpest declines in stock prices so far!). Stocks went completely no-bid. How do you even know what your stock is worth without a buyer?
So, the stock is falling, there aren't any buyers, no price can be established. Everyone is quaking in fear. Then, a masked man steps forth from the shadows and boldly declares "I'll buy your stock!" and names a price. Who is this mystery buyer? The short seller who is taking profits on his short position!
- By providing a large number of buyers in a time when everyone is selling, or conversely providing a large number of sellers when everyone is buying, short selling provides market liquidity and price stability.
Short sellers cannot destroy solvent and stable companies. Short sellers contribute to price discovery.
A solid company that pays dividends to shareholders cannot be destroyed by short sellers. First of all, putting aside certain situations when companies use ownership of their own stock for capitalization purposes, a company's operations and finances drive its stock price, not the other way around. While the stock price will rise and fall in sympathy with the company's fortunes, company operations are not affected by the stock price. The only time a company actually receives any money from stock issuance is at the Initial Public Offering or when they issue new shares of stock.
Consider you have a random public company X. That company owns some capital assets (production equipment, computers, etc), has a cash reserve (hopefully) that is also part of its assets, has some employees, trade secret production data, etc. The company utilizes its employees to operate these assets and produce some useful item that people want to buy. The company's customers then give company X money in exchange for its goods. Some of this money is then remitted to shareholders as dividends. No part of the above process has anything to do with the company's stock price. Whether the company's stock price is $1 or $100, if it has a fundamentally solvent and profitable business, it has a solvent business.
For this reason, if your company makes $1/share in profit, for example, the stock price can never be driven down to $1, because then you could simply buy the stock for $1 and make a 100% gain in a year. This event can simply never happen, because if it does, it creates an incredible deal for anyone to buy, and any short seller caught on the wrong side of that trade will be killed.
The only companies "at risk" from short sellers are companies that do not have earnings or the prospect of good earnings going forward. There's a reason why Citibank and Bank of America have their stock prices at close to zero, while Intel is trading at $15. Intel has certainly taken a bath in this market, but it still is a solid company with good fundamental business prospects that makes a product people want, so its stock price has somewhat resisted the assault of the downturn, while C and BAC are close to zero.
The philosophy that the government should use technical means to prevent market declines is flawed
The banning of short selling, and the younger brother of this policy, the "uptick rule", are examples of the SEC attempting to stop market declines by preventing or hampering the profitability of betting on market declines.
However, as the failure of the financial short-sale ban has shown us, this is impossible and only makes matters worse. As I note above, there is no trick the government can use to make a market filled with unprofitable companies go up or stop declining. The only thing that can help the situation is profitability on the part of the companies that make up the market. Driving out market participants on either the long or the short side simply decreases liquidity and contributes to inefficient markets.
Commenters in other threads have noted that the "uptick rule" prevents a piling-on of short sellers driving the price down. But these same people aren't in favor of a "downtick rule" to stop buyers driving the price up.
In my view, the government's job in the capital markets is not to ensure that the market "always goes up", no matter what the impact is on investors. "Government by Dow" is a terrible idea that has led to atrocities like the TARP.
The government's job in the capital markets is to regulate the capital markets by providing transparency, forcing all information in capital market transactions to be disclosed, enforcing the law, controlling leverage, and to have consistent regulatory regimes so that all market players understand the rules. This includes (in my opinion), never allowing any institution to get "too big to fail", and forcing insolvent institutions into bankruptcy quickly and predictably.
If the government had done these activities properly and been less concerned with the market "always going up", the kinds of issues we've had with the capital markets recently would never have happened.
Short sellers are not the enemy. Short sellers are a necessary part of the process of discovering what stocks and bonds are worth, thus allowing all of us to participate in efficient markets.