Getting to grips with short-selling

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To many who work outside the stockmarket, short-selling is a peculiar thing. Selling something you don't own hoping to profit from a fall in its price before you buy it back is hard to get your brain around.

In fact, 'shorting' is frequently touted by its advocates as one of the safety valves of the market. The idea isn't as daft as it sounds. Conventional short sellers, while selling something they don't own personally, are usually selling stock they have borrowed from a long-term holder. When they subsequently buy it back, they return the shares to their rightful owner. The lender of the stock charges them a fee for the privilege.

It is a curious business, though. Short sellers can have a depressing effect on a share price, which is inherently against the interest of long-term holders of the stock. So why lend to allow a speculator to take out a position that can reduce the value of your investment?

The answer is that some institutions don't participate in stock lending. Those that do it reckon that no long-term harm is done. They reason that they may as well make money out of the pointless zero-sum speculations of shorter term traders in the market.

It is this question of whether short-selling is a zero-sum game or whether it is a pernicious practice that can inflict real damage on a company that is at the root of the recent controversy about the practice. Short sellers argue that they provide a contrary view in the marketplace that is usually dominated by bullish cheerleaders for a particular company's prospects, whether it is the company itself, its house brokers or investment bank analysts who want to keep in with management. Short sellers argue that by counteracting this bullishness they are providing liquidity that would not otherwise be there.

Short sellers are not necessarily bears of the market. Some may simply be shorting one stock as a hedge against a large position in a similar one. And in any case, it simply will not do to claim that short-selling is morally bad because it is betting against a company, any more than it is morally good to promote one as cheap. Investors invest to make money, not to make moral judgements. And there are just as many investors who have been hurt by buying into shares that have been driven to unsustainably high levels by bullish analysts, and have then collapsed in price, as there are investors who have been hurt by short sellers driving a price down. It's all part of the rough and tumble and risk of the market as a whole.

Some practices used by short sellers are less than lilywhite, however. One is shorting a stock and then spreading rumours that the company is in trouble. The best shorters are the ones who find out the real bad news about a company and do the market a service by publicising it to make sure that the stock sells at the 'right' price. That's OK. It's fabricating bad news that is less savoury.

Technical factors in the market also mean that it is possible for some right issue underwriters (in fact, strictly speaking, they're sub-underwriters - institutions taking stock from those whose job it is to parcel the underwriting of an issue) to short the stock they are underwriting in the knowledge that the short position can be covered by the stock they are due to receive if the issue is left with the underwriters. You can view shorting in these circumstances as a defensive move to lock in a profit, but it also has elements of a self-fulfilling prophecy.

Regulating short-selling is almost always a knee-jerk reaction by regulators during a sharp market fall. In the US in the past few months, the Federal Reserve imposed a circuit breaker type of regulation. This has since expired and will not be renewed. In the UK there are moves to attempt to control short-selling in rights issue situations by requiring extra disclosure.

Peter says

Complaints about short sellers usually ring pretty hollow to anyone who has been involved in the market any length of time. The complaints occur because investors want someone to blame for their own bad judgement calls. Complaints only happen when share prices go down. No-one, be they companies or investors in their shares, ever complains when share price are talked up. So why penalise short sellers because they make money during those relatively brief periods when the market is consistently falling?

Complaints from banks ring particularly hollow. Banks make a lot of money from administering the back of offices of hedge funds (so-called 'prime brokerage' business). That includes dealing with the mechanics of short-selling. Since hedge funds are the main short sellers operating in the market, the banks can hardly expect much sympathy when the short sellers turn their attention on them too. In any case, banking sector managements are, it can be argued, no more or less than the authors of their own - or rather their shareholders' - misfortune.

Private investors can try their hand at short-selling through financial contracts like spread bets and CFDs. But it isn't as easy as it looks, and can be particularly dangerous if leverage is involved. It's an easy way to lose money if the market turns the wrong way. Investors being by nature optimistic, we find it easier to understand an investment proposition that involves buying something that may appreciate in price. Doing the reverse comes hard for most of us.