Why Short Sellers Are the Heroes of Wall Street
I'm expecting a lot of nasty e-mails on this column, but the truth needs to be told. Short-term traders, especially short sellers, are often blamed erroneously for manipulating stock prices, forcing them down far below their real value, and for creating crashes and general chaos on Wall Street.
In fact, short sellers have been identified as so vile by SEC Chairman Christopher Cox that he has banned short selling for some 980 publicly traded companies. Chairman Cox and other critics of the market blame short sellers for several grievances:
- Short sellers destabilize prices in a shaky market, and in a panic can make matters worse, causing a crash.
- Short sellers artificially engage in "bear raids," where traders gang up on an illiquid - or thinly held - publicly traded company and push the price way down below their intrinsic value. After the stock plunges, traders cover their shorts and buy up good companies at bargain prices.
By temporarily banning short sales, Chairman Cox hopes to prevent the stock market from declining further. (So far he has been unsuccessful.)
So who's right, the short-selling proponents, or Chairman Cox? The best way to determine the truth is to look at what short selling is, and the evidence on what it does.
What Exactly is Short Selling?
Short selling is a way for investors and speculators to bet on falling prices, and for long-term investors to protect their investment portfolio during a bear market.
Most investors profit from stocks by buying a stock and then selling it when the price goes up. Short sellers do the opposite. They sell a stock first and then buy it back when the price goes down.
- Short sellers accomplish this by borrowing the stock first and then selling it. To close their trade they purchase the shares, hopefully at a discount. When they buy the stock back, they return the borrowed stock to the owner and pocket the profit from the difference in price. Short sales must take place in a "margin account" because the sellers are using borrowed money.
- "Naked" short selling is more controversial. It's defined as a short sale by brokers/dealers who sell a stock short without borrowing it first. The SEC recently banned this practice as well.
- Investors can also sell short a stock that they own. This is the least controversial technique. It's often used at the end of the calendar year to lock in profits in a stock that has gone up in price.
But with the potential positive and negative aspects of short selling, what do the facts from the scientific community show?
Adam Reed, a finance professor at University of North Carolina, and Arturo Bris, a finance professor at Yale, have done extensive studies on short selling. He has come to the following conclusions.
- On bear raids: "In recent years, when academic researchers have looked for bear raids - even in those areas in which investors suspected that they existed - they haven't found them." They couldn't even find evidence of bear raids on 19 beleaguered financial stocks. They conclude that short sellers reacted to downward momentum, rather than caused it. "Typically, short sellers trade in response to past negative news," Professor Bris said, "rather than inducing current stock price drops." (Note: While bear raids are unlikely in mid to large companies because of their size, I do think that short sellers can artificially manipulate small-cap and penny stocks. I've seen it too many times!)
- On short selling causing greater volatility: Professor Reed found just the opposite, that "stocks without short selling not infrequently trade at prices that deviate widely from their true value."
3 Major Advantages of Short Selling Stocks
Academic studies also show three major advantages of short selling stocks:
- First, they counter the "irrational exuberance" that company officials and bullish promoters parade about their stocks, and encourage a more sensible valuation of a company's worth.
- Second, short selling is a legitimate way to hedge your position. It is not simply a strategy to profit from falling prices. Major institutions and conservative investors often use short selling to lock in a position for a period of time, and protect themselves from downside risk.
- Third, short sellers and short-term traders provide extra liquidity and thus reduce bid-asked spreads. It is short-term speculators that allow long-term investors to sell when they want to.
From a practical point of view, while short selling of individual stocks is temporarily prohibited, investors can still play the down side of the market by buying short exchange-traded funds (ETFs), such as SHORT S&P500 PROSHARES (SH).
Professor Bris concludes with this word of caution: "The ban on short selling may prolong the crisis in the sense that it will now take the markets longer to adjust to the true values of financial companies."
Short sellers and speculators are in fact helping us make the markets more efficient and more profitable for investors. In today's market environment we can use as many of these heroes as we can get.
Let's hope Chairman Cox comes to his senses and reverses his ban on short selling soon.
Related Articles
|
Top Rated Comment Streams:
-
1.Hedged In662
- 2.
-
3.Smarty_Pants422
-
4.axelrod608330
-
5.The hand277
- Free E-Newsletters
- About Seeking Alpha
- About Us
- Contact Us
- What's New
- Readers Feedback
- Advertise With Us
- Contributors
- Contribute an Article
- Feature Your Book
- Our Contributors
- Anonymous Contributions
- Dispute an Article?
- Legal
- Terms of Use
- Privacy
- Copyright
This article has 10 comments:
-
msoori
-
71 Comments
My Website
Oct 15 08:42 AM-
Chris Dunn
-
3 Comments
My Website
Oct 15 10:09 AMChris
-
carey_jim
-
559 Comments
Oct 15 11:29 AMFor example, right now many of Christopher Cox's friends are selling him short by not inviting him to parties and going long on someone else instead, and many are still long on him.
Only the future will tell which of these friends will profit socially (and financially) by their actions.
Maybe naked short sellers are like Groucho Marx who said "I would never attend a party given by someone who would invite a guy like me."
(He probably crashed parties where he wasn't wanted instead.)
-
Gaucho
-
131 Comments
Oct 15 01:09 PMWe know you are a mouth piece for the hedge funds.
-
jcreech
-
3 Comments
Oct 15 01:27 PMThe three things I would add to a regulatory scheme are: (1) end of the day verification that any shorted shares involved a legitimate borrowing of owned shares (which may be onerous enough to have a chilling effect on shorting), (2) a public filing with the SEC by those who short 5% of a company's stock (equivalent to the long requirement already in place), and (3) the resources and backbone to enforce SEC regulations.
-
sumosama
-
237 Comments
Oct 15 02:11 PM-
train wreck
-
3 Comments
Oct 15 03:49 PM"They couldn't even find evidence of bear raids on 19 beleaguered financial stocks." I suggest you take a closer look at the raw data (www.deepcapture.com/wp...) before supporting these allegations. Morgan Stanley's market was raided in the days leading up to teh ban on short sales in September and, if you make note, the level of daily short sale volume was near identical to that which it was before the ban was put in place. And to think, with restrictions on short sales, how can one say sales that should not have occurred did not play a part in the market sentiments.
The problem with these economists who have become the mouth pieces of the hedge funds, they never seem to present the raw data that supports their "conclusions"...
-
mountain1228
-
1 Comment
Oct 15 11:42 PMAs you said Short Sellers make money off companies that are going under because the market for this situation exists. Therefore, what amount of profits have been lost as a result of the current government *protection* scheme?
The current *financial crisis* should have been a potential gold mine for short-sellers and their success would have helped end the current panic quicker.
This success would have brought on the current bank merger process at an earlier time, avoiding the intervention of the central monetary authorities.
-
Gaucho
-
131 Comments
Oct 16 09:30 AMGive me a break
"Basically, the SEC banning short-selling is socialism. Plain and simple."
You must think every one on this board is an idiot.
Again you suck at this issue so take you carpet bag and get lost
-
byrnemm
-
19 Comments
Oct 17 02:11 PMi.e. - Google releases a solid earnings report and becoems such a popular company that everyone wants a piece and everyone starts buying, even to the point where its value is above where it should be. Short sellers are the intelligent people that are able to see this discrepancy and capitalize off it. I say intelligent because if they screw up and the stock goes way up the losses are limited only by margin calls.
everyone agrees naked short selling is bad. it violates nearly all economic principles. get over it - there is a difference.