First, short-selling is when I borrow shares and then sell them. I buy those shares back at a later date and return them to the lender. If the stock moves down I make money.
For example, I borrow a stock at $45 and sell it. I get $45 in cash. A few weeks later the stock is at $35, I buy it, and return the shares. I made a $10 profit.
I tend to think short-selling gets demonized by many, especially corporate executives looking for an excuse, but it serves a very useful purpose:
- Price Discovery. Increased selling pressure helps stocks find their true value. Let’s say a stock is trading at $50 a share. A short-seller believes the true value is $30. In this instance the short-seller is correct and the stock is worth $30. The market will eventually reflect this value; however, the inability to short-sell the stock will only make the stock’s fall to $30 more drawn out.
- Short Covering Rally. When markets crater, short-sellers often put a floor on the losses. Why? They lock in their gains by buying the stock back.
- Liquidity. The more traders of a security the more liquid. The more liquid a stock is the easier it is to enter and exit a position. More short-sellers = more traders = more liquidity.
- Hedging. Being long a stock and going short in the same stock can help mitigate loses.
- Finding the Truth. It helps expose companies like Lehman. If a short-seller can illustrate effectively why the company is worth less than the market perceives it, he or she can assist in finding the true value of a company.
Further, executives and commentators are usually pumping up a stock. Why isn’t that rumor spreading met with the same vitriol?
There are probably more reasons why short-selling is a necessary evil. I just wanted to provide a bit different perspective by illustrating why short-selling bans, like what is taking place in parts of Europe right now, are at best ineffective (price discovery) and at worst harmful (short covering rally, liquidity, hedging, finding the truth).
