The real effect of short sellers on a market
Originally published at marketprotocol.io.
Shorting is a common practice among traders, despite the risk of theoretically unlimited downside, because the practice can be incredibly rewarding and has utility for those who are looking to hedge their investments.
Short selling enables a trader to profit from declining prices. The trader generates a profit by selling an asset at one price and then buying it back at a lower price. For example, if a trader sells one share of Tesla stock (TSLA) at $375 and buys it back at $275, then the resulting profit would be $100.
Aside from speculation on prices declining, shorting is also extremely useful because it allows a trader to hedge an asset, offsetting potential losses by sacrificing potential gains in closely related markets.
Short sellers have an image problem in the mainstream media. The collapse of construction giant Carillion has brought short sellers negative attention. It was reported that several hedge funds, some with short positions of around 2% of Carillion, made a huge profit when the business went under. While the media are usually keen to look for the nearest scapegoat, the reality is that the company was showing signs of weakness. However, short sellers got caught in a cycle of negative perception because they profited from Carillion’s misfortune.
What is less reported on, specifically in overvalued markets, is the effect of the ‘wisdom of the crowd’ on the price of an asset. Typically traders look for assets that are underpriced, but some traders are inherently better at noticing when an asset is overpriced, and short selling is the mechanism by which they can sell overpriced assets.
Shorting aids price discovery
Short sellers help move markets back into balance by putting downward price pressure on overvalued assets. According to research published in the Journal of Financial Stability that explored the impact of short selling activity on market dynamics in Turkey, short sellers help contribute to the market effectiveness and short selling activity leads to higher liquidity and decreased volatility. Although this research is country specific, and the state of the economy at the time must also be taken into account, the researchers also suggested that a lack of short sale activity could actually damage the market and negatively impact financial stability in general.
Bans on short selling hurt markets
In times of financial crises, market regulators have imposed bans on short selling, specifically for stocks of financial institutions. During the ‘08–09 crisis, it was proposed that falling bank stock prices could result in banks facing more difficulties, triggering further price drops, and that bans on short selling these stocks would counter this and prevent insolvency. However, a study on short selling bans and bank stability reveals the contrary; bans imposed during that period slowed down price discovery, hurt market liquidity and produced stronger declines in bank stock prices.
While regulators and the media alike blame short sellers for market declines, research indicates that short sellers correct overpricing and contribute to a higher level of liquidity and market efficiency when they are allowed to short sell without restriction.
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