Why Shortsellers Aren’t Villains

A ban expired today that had prohibited the shortselling of certain stocks in the financial sector. Unfortunately, it is common practice to villainize  those who short a struggling stock, and in this case to actually ban it. This mentality is so pervasive that Jim Cramer actually jumped on board on his popular show, Mad Money on CNBC. Jim Cramer is pretty popular around these parts for his preaching of solid fundamentals like diversification and his harsh criticism of the creation, packaging, and evaluating of subprime mortgages that led to the crisis, but on this issue at least, his position doesn’t make much sense.

Essentially, to short a security is to sell it without already having a position in it. Effectively these traders are selling a stock, and then buying it back to get back to a neutral position. Obviously this is profitable only when the price drops and they can buy the stock back for less. It is for this reason that the media labels it with the cliché of “betting against the stock”, which is probably part of why people view it so negatively. It definitely brings to mind this image of dishonest gamblers betting on the economy failing.

Shorting really is not that much different than any other transaction. There’s a buyer and a seller. The market clearing price, the value of a share, is whatever equalizes the number of buyers and sellers. Part of making that price fair is that people that have reason to believe a company is overvalued should be able to express their opinion about the price and make money by doing so. If you restrict selling to people who already own the shares, the price may become artificially high and no one will want to purchase the overvalued stock. The last thing any economy needs is to artificially prop up stock prices at the cost of trading volume and liquidity, but especially when there is already a crisis of liquidity.

There simply isn’t much validity to the claim that these short sellers are just ruining healthy businesses. If the business is so healthy, then investors will buy and bring the price right back up. Shorting quality companies simply is not a rational strategy. It really is time to move past the image of short sellers as villains that destroy stocks. Essentially, the bad expectations are still out there, and the market will only function efficiently if these are embedded into the price.

During Brown University’s October 3rd Roundtable on the Economic Crisis, Economist Matthew Rothman expressed this point of view passionately and eloquently, and the video is available online as of this article’s posting. The author attended this event, and there were a good deal of interesting points raised that will hopefully be discussed in future posts.


4 Responses

  1. While short-selling is an important part of keeping an efficient market, the damaging practice that was being carried out was “naked shortselling” where you short sell the stock and never actually find any stock to sell. Normally, a broker has three days to find a stock to sell, but there is speculation that many were just ignoring that requirement. Also, I’ve heard Cramer talk about bringing back the “uptick rule” to prevent the massive driving down of a stock’s price through continuous shorting. The uptick rule basically says that you can’t short sell a stock until the last trade has resulted in an increase in the price (or an ‘uptick’) Not only does it prevent manipulation, but it apparently also helps calm the markets from irrational traders who only see the price taking a dive.

  2. I see what you mean about the uptick rule and elimination of naked shortselling being potentially beneficial. I’ve heard Cramer express support for both (a post that can best be termed angry approval of his position on naked shorting can be found here and this documents his approval of the uptick rule).

    What surprised me was that in the midst of the chaos following the failure of the first iteration of the Paulson plan, he expressed agreement with the actual banning of all shorting of financial companies. That struck me as a case of simply blaming the short sellers, but in his (and the government’s) defense, if the ban was meant to just buy a few days and resolve the underlying flaws maybe there was some merit. It’s clear though that banning the shorting of a struggling sector is not a strategy that can be used for any great length of time.

  3. great discussion I have a few points that I disagree on but other then that you guys probably should go to Jim Cramers blog spot

  4. Thank you, thank you, thank you.
    Banning short selling was the epitome of foolishness. It’s like banning having a fever if you want to cure someone of the flu.
    We need to treat the cause, not the symptom.

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