It's easy to assume that when stocks rise, everyone profits, the investors get more return out of their
investment and company's prospects improve with higher share prices.
However, that's not the case for short sellers who look for profit by betting against the success of a
company or the market.
Thirty four billion dollars.
That's the on paper losses short sellers have incurred year to date betting against
Tesla. Short sellers gain when someone else loses.
It's like if you took out an insurance policy against your neighbor's home and your neighbor's home was
destroyed. Short selling has always been seen as a controversial practice during times of great
financial distress, Short sellers have often been blamed for causing the drops in the market.
Short selling has always existed.
It's been a part of the normal trading process on the exchanges since exchanges
started. We've seen short selling increase recently in a more broader spectrum
of names. Despite the controversy, the practice has stayed in the limelight, even as hedge funds took a hit worth
20 billion dollars, shorting GameStop just this month.
Many are sticking with the trade.
The conversation around it these days is there's new participants and there's new folks
getting involved here and taking advantage of what shorting has
allowed investors to do.
So how did short selling become such a common practice in the US market?
And what impact does it have on our economy?
The process of shorting a stock usually involves three players, the short seller, a broker and the market.
short sellers first identify a stock that they believe will decrease in price over time.
Then they borrow these stocks through a broker, selling them directly at the market at their current price.
As the price drops or when the price drops, they buy back the stock at a lower cost to pay
back what they borrowed, pocketing the difference between the sale price and the buy price for profit.
If you like something you buy it, so same thing with a stock.
You're going to buy the shares, buy the stocks that you like.
If you don't like something, you say, well, that's stock is going to underperform.
I don't think it's in a good market.
I don't think that it's management is good.
I think it has too much competition or I think its stock price is just way too high.
Well, the only way to to make money off that is to short the stock.
Short selling remains an enticing investment strategy for many reasons.
It's one of the few ways that an investor can make money in a declining market.
And it also provides a method for investors to hedge their portfolio.
So, for example, suppose there are two companies in the same industry and you think one of those
companies is going to do even better than its competitor.
Now, if you wanted to place a bet on its success, you could buy shares in that company.
But if you're worried about the market crashing or that industry struggling, what you could also then do is short
its competitor. So that means you're going to profit if your company that you're optimistic about does well
and you're also going to profit if the company you're less optimistic about does poorly and you're going to
benefit based on the difference in their performance.
Short selling is not just done by large hedge funds or other investment entities.
Individual retail investors can also participate as long as it's approved by their brokerage.
However, experts warn that retail investors should understand the risk.
I think it's important that if you understand exactly what you're doing
and you see a weakness in the market or an opportunity, and you
have really weighed out risk management, I absolutely think retail investors
should participate in this part of the market.
That's because when shorting stocks, the potential loss can sometimes be unlimited.
Tesla's short sellers saw about a 38 billion dollar loss solely in 2020, and the game
stopped short squeeze of 2021 cost about 91 billion dollars for short sellers betting against the
company. When you buy a stock or you can do is lose what you put into the trade.
So if you bought a stock for 10 bucks, you can only lose 10 dollars.
If you short a stock for ten dollars, your upside is limited by it going to zero
so you can make ten dollars.
The problem is if the stock goes up to 100, you're going to lose 90.
So you put ten dollars into the trade, but you can actually lose ninety dollars.
So what we say is shorting stock has unlimited losses, limited profits.
Short sellers have a bad reputation, frequently blamed for causing drops in the market after they were accused
once again for a huge sell off on Wall Street that linked to the crash in 1937, SEC, or the
U.S. Securities and Exchange Commission stepped in to regulate the shorting market.
Regulations are done by the S.E.C.
primarily we have Reg SHO, Reg S-H-O it's called, which
has a lot of the rules on short selling.
One of the first regulations that the SEC passed was Rule 10 A1 better known as the uptick
rule. It essentially restricted short selling in a declining market, allowing short sellers to only
short stocks during an uptick.
The rule was eliminated in 2007 as electronic trading began to take over Wall Street and was
replaced by a far less restrictive rule in 2010.
Since then, several named investors have suggested reinstating the uptick rule to decrease the volatility in the
market. In the last half hour, On Friday, the S&P moved like 100 handle points.
That's just it's not related to economics now, you know, and it's as simple as that.
So what does the SEC lose by announcing they're going to go to a 30, 60, 90 day trial
period to reinstate the uptick rule, to see what effect it has on markets, whether it makes markets more orderly?
What do they lose?
On the flip side, however, traders argue that the original rule wasn't as effective as some make it to believe
in practicality.
It wasn't that effective.
And you have to understand that there is something going on with with people shorting stock.
It creates liquidity in the market.
So let's say, you know, someone wants to buy and there's no sellers.
You know, there's no long shareholders willing to sell stock.
Well, it's a short seller that is there that creates steps and it creates liquidity for more buying because they're
willing to sell the stock.
So, you know, there's a double edged sword here where, you know, if you start limiting short sale executions,
you start limiting liquidity in the market.
Despite the controversy surrounding short selling, many investors and experts have come out to defend the
practice. Former SEC chairman Jay Clayton publicly argued against short selling
bans, describing it as a necessary practice to facilitate ordinary market trading.
Even Warren Buffett has said that financially sound companies can potentially benefit from short sellers.
Short selling is something that can exacerbate other problems in a market, but short selling
itself is not- There isn't an economic reason why short selling on its own is
bad. You know, when times are booming and people are promoting stocks left,
right and center and investors are speculating on margin and often urged to do
so, whatever the venue might be, whether it be TV or print or whatever.
I would argue that far more financial damage is done to investors by that behavior
than any behavior might be by fundamental short sellers who by and large, in an
environment like today are net purchasers of stocks.
Other countries in Asia and Europe have banned short selling during times of economic uncertainty.
Most recently, the culprit 19 pandemic caused countries like Austria, Belgium, France and
Indonesia to temporarily restrict the process.
Some studies, however, show that a ban on short selling actually does more harm to the market than good.
During the financial crisis between 2007 and 2009, regulators actually banned short
selling temporarily in response to the large drops in the stock market.
Now, was this a good policy or bad policy?
Regulators have since expressed that they regretted this policy action.
Short selling plays several important roles in the market, including accurate price discovery and detection
of fraud. If it wasn't for the short sellers, there'd be a lot of long shareholders buying and bidding up
a stock that had really no value.
So shorts provide price discovery.
They're sitting there and they're going through their reports and they're, you know, they're
visiting companies and they're saying, wow, you know, you're telling me that you're doing this in sales?
I don't see it. I think I gotta short this company because something looks a little fishy here.
People don't get upset when they're making money on the upside.
They look the other way on bad corporate behavior.
The short sellers, the journalists, the naysayers will be pointing out that a guy is doing this.
He's doing that. He's obviously lying.
And people will shrug and go, eh so what.
The stock's going up. But when people start losing money, boy, do they get upset.
Although shorting by itself might serve a purpose, experts warn that social media and meme stocks could
bring about changes to the practice.
I do think that intersection between social media and the market is
one that we need to be thoughtful about and really understand.
The way people communicate and connect these days is very different than it was twenty five, thirty years
ago. A short sale, just like a long buy, is great.
It's active participation in the market, the chatter behind it, talking your book,
you know, giving little false ideas or statements.
That's what's really wrong with both long and short sellers.