Honest question; if I had a magic wand and tomorrow banned all short sales, what would be the negative side-effects? From a lay-person's perspective, short selling seems pretty horrible, but very often I find that there are variables to this that I do not fully understand, and I know some people here are more financially literate than I am.
During market draw downs it's the short sellers that are buying first. Without short sellers bubbles would get bigger because no sellers taming them and their bursting would be much harsher as you would only have sellers. Shorting also allows one to invest in a company while shorting others in the sector in order to invest in a company while hedging broader economic risk. Also buying put options allows you to insure your own risk. These are sold by market makers that are able to hedge their own position by short selling, without short selling no more insurance.
> bursting would be much harsher as you would only have sellers
I'm not sold on how much of a cushion that is. Shorters want it to fall as much as possible, in an ideal world all the way to zero so they don't effectively owe anything. There's no reason for them to buy until they think it's hit bottom and they also have incentives to drive the price lower with bad press and any other manipulations they can think of.
One core place that shorting is key (which isn't touched on much) is shorting/going long on commodity futures. Very simplified example below:
If I'm an airline (and my business is dependent on the price of oil) and I think the price of oil will go up, I will hold some amount of oil futures at the current price. If the price of oil rises, my company is "hedged" against that rise. This is good for the buyer of the commodity. If the price of oil goes down, I lose on my future, but my business is fine overall.
Correspondingly, if I'm the seller of a commodity (I own an oilfield), I might short oil futures, in case the price goes down. I make less money selling my oil, but I hopefully make some back on the short
Short selling unearths fraud. Check out some of the shorts Muddy Waters had against fraudulent Chinese companies, or the short positions against Wirecard. The latter was a complete fraud aided by German regulators and finally taken down by shortsellers and the Financial Times.
A great book on a specific example is David Einhorn in "Fooling Some of the People All of the Time". He routinely finds fraud and shorts them, in this case, Allied Capital.
Shorting stocks, in general, is a beneficial action for the market because it helps prevent shares from becoming overvalued.
I think this situation has actually highlighted the fact that shorting stocks needs to be easier. Currently, it's too easy to purposefully trigger a short squeeze.
With the goal of efficient prices in mind, short squeezes are bad, and enabling shorting is good.
The second order effects are problematic though. Someone shorting a stock has an incentive to see a company fail. Sometimes people will put out rumors or even go on fiance shows talking about how poorly run some company is. Maybe they make a discreet call to their buddy at the ratings agency and have them downgraded a step. If the market's stated purpose is to help companies find the capital they need to succeed, then short sellers run counter to that purpose.
If however the purpose of the market is to be a big game for people with huge amounts of mostly virtual currency to gamble with then short selling is a vital instrument.
One problem with the market is that value is not based on what a company is worth, it is based on what investors think it might be worth in the future, which is largely just a guess. So the whole thing becomes divorced from reality while investors play games with each other to try to make the numbers go up as fast as possible.
> Sometimes people will put out rumors or even go on fiance shows talking about how poorly run some company is. Maybe they make a discreet call to their buddy at the ratings agency and have them downgraded a step.
Some people buy a stock, and then put out rumors or even go on finance shows talking about how great this company is and how its stock is undervalued. And then sell it at the peak, leaving others holding the bag. Yet people don't run around saying that we should ban people from being able to buy stock because of that.
Both the scenarios (the one you describe and the one I describe) are illegal market manipulation. Sure, I would not be surprised if market manipulation of the short side were vastly underprosecuted, but I don't think that's a reason to complain about short selling per se.
Yet people don't run around saying that we should ban people from being able to buy stock because of that.
I honestly wonder if we should sometimes. I struggle to see how the real value created by this whole system outweighs the negatives. It’s been abstracted too far away from "investing in a company" and created too many perverse incentives. Too many people playing numbers games and gambling, under the impression that they're creating value somehow. HFT? How is that anything but absurd?
I feel like we’d be better off going back to a more simple system where actual people have actual skin in the companies they're taking ownership of.
HFT (electronic market making in general, HFT being a particularly potent expression of it) drastically lowered transaction costs for retail investors, and most theories of how HFT is harmful or absurd are based on a lack of understanding of market structure. Is how it's something other than absurd.
Oh, I wouldn’t even call my idle layman thoughts a theory, more of a hunch really.
Have retail investors generally benefitted from doing an amount of trading that would incur significant transaction costs?
Do you think my general sentiment is off base, and the market (as is) is unequivocally a good thing for society as a whole? Even with regular worldwide crises caused by wild speculation, greed, and incompetence?
I would be very interested to read a thorough defense of how the increasingly complex market machinations and instruments are good for “the people” and some indication that their value isn’t entirely captured by the small cohort that dreamed them up. I admit that I understand this very poorly.
A thing retail investors have always done (placing orders to buy and sell stocks) used to cost a lot. Now it's practically free. You can flee to a more abstract argument about whether investing itself is bad, but I'm not interested in debating that, only in observing that HFT had a large hand in eliminating those costs.
I note further that you only attempted to rebut one of the two points I made in my comment.
That’s been my argument/question all along, though. I started off with the sentiment that maybe we should stop people from buying stocks, period. HFT was not the main thrust, I can easily claim that you’ve sidestepped my points as well.
Anyway I’m not trying to debate, I thought it was clear from my last post that I’m not an expert and I’m really just asking questions (sincerely, not rhetorically) and seeking to gain more understanding of the market and its macro-level, “big picture” effects on society.
I'm not interested in and take no position on your broader argument. I'm exclusively interested in: "HFT? How is that anything but absurd?". I think that's easy to refute. If we agree, we agree, that's great.
So HFT is not absurd because it lowered transaction costs for retail investors. What mechanism did it achieve this by?
I call it absurd because computer algorithms trading stocks at the microsecond level seems completely divorced from the theoretical basis of “investing.” I don’t understand how it makes sense on a theoretical level. Reducing transaction costs doesn’t seem to explain that.
For example: HFT-backed trading systems enable companies like Citadel to quote better spreads to retail traders than to hedge and mutual funds, which is why PFOF arrangements are structured in terms of how much better their prices will be than the actual exchange (which they are required to at least match, by regulation).
It's probably the case that no one person needs to make a microsecond-scale trade. But, obviously, there are many people trading, not just one, and making things very fast is one way you make things scale. In reality, though, extremely high performance is probably more important as a vector for competition, which is ultimately what brought spreads down.
Thank you. I definitely have some reading to do in trying to wrap my head around all of this. At first glance, it does seem like some people in the industry (Charlie Munger, Michael Spence) share my perspective (though Munger could just be strategizing).
You know who is almost certainly not strategizing? Vanguard, which is probably the most trustworthy firm in all of finance. You can look up what they've said about HFT, too. :)
I keep coming back to these fundamental questions. HFT (and market making in general) increases liquidity. Why is liquidity a good thing? Why should it be so easy to quickly buy and sell ownership of companies? To me that seems like a bad thing. I feel like I’m just missing some fundamental understanding.
As a powerful investor, you can buy a large position in a company, lobby for changes that increase the short term value of the stock, sell it, and move on, likely destroying it in the process, leaving all of the people who were actually invested in its success holding the bag. Is that to be seen as a net good? It seems like HFT and other instruments are just taking that concept to ever more extreme levels.
I was more specific than "liquidity". I said "reduced spreads and lowered trading costs". It is better for you to pay less to execute a trade than to pay more for it.
I don't know what an HFT MM has to do with people manipulating the stock markets directionally.
Sorry - I was referring more to some other stuff I was reading than anything you said.
It has to do with it because it enables it. It's part of abstracting investing away from providing capital to companies because you believe they will succeed. Somewhere there is an argument for why these abstractions are beneficial to more than just the people profiting off of them. Why do you keep studiously avoiding engaging on this?
I'm interested in discussing things that are knowable, and where I have some chance of learning things. You said that HFT was absurd. It was easy to point out that there are real, practical benefits to HFT (those benefits become even clearer if you do some reading on how crooked the human-scale market making system was prior to HFT; Google, for instance, [odd eighths]).
That's the extent of my interest in this discussion. If you do some research and find out something that refutes my argument about HFT, I'd be interested in learning about it. Otherwise, I think if we're on the same page about this detail of the thread, it's fine to leave it there.
The stock markets purpose isn’t to help companies find money, that Pr spin.
It’s to help investors invest their monies more cheaply and safely. The side effect is that companies get cheaper access to investment funds.
Without short sellers frauds would be even more prevalent, investor costs would be higher and companies would raise less money.
If you have a solvent company brought down by a short seller, you never had a solvent company.
And value != price. True investors like Buffett don’t really mind the casino aspect, because volatility creates opportunities when value diverges far from price.
> The second order effects are problematic though. Someone shorting a stock has an incentive to see a company fail. Sometimes people will put out rumors or even go on fiance shows talking about how poorly run some company is.
“ Tesla CEO Elon Musk had a number of things to talk about during Wednesday's quarterly earnings call, but spent a lot of time discussing the company's Full Self-Driving system. According to Musk, the FSD will be capable of Level 5 autonomy by the end of 2021.”
How is Elon Musk claiming (lying) that level 5 FSD will be available for Tesla vehicles in 2021 any different from short sellers making similar claims about the potential downsides of a stock?
FWIW, Elon Mysk said they’ll have a million robotaxis operating before the end of 2020. I believe there are 0 currently operating. [1]
I will bet anyone 10,000 dollars that Tesla will not have level 5 FSD by EOY. If anyone is willing to lend me money to make the bet, I’ll bet as much as they’ll lend me.
Because he works there. He has the most information possible. He is not guessing. The SEC is quite clear about how this has to be honest disclosure. He has been rebuked several times for this. It is not unreasonable for companies to miss targets and when the forward looking information they provide at investor briefings may be less trusted and this would normally be reflected in the stock price change.
Experienced investors make long term investment decisions with this sort of thing in mind. Not everything goes to plan but if this was fabricated it would be illegal and is very commonly pursued by the authorities.
> With the goal of efficient prices in mind, short squeezes are bad, and enabling shorting is good.
Yeah? Aren't they equally useful as market messages?
If I am willing to tie up some money holding an instrument afloat at overvalued prices longer than you are willing to remain in your short position, haven't we ultimately, together in our conflict, created a useful message about the underlying asset?
Maybe I think Company G is worth $20 but not $40, but if you are selling it short at $5, and I'm prepared to be illiquid for a while, don't I send the correct market signal by squeezing you out of your short?
> Maybe I think Company G is worth $20 but not $40, but if you are selling it short at $5, and I'm prepared to be illiquid for a while, don't I send the correct market signal by squeezing you out of your short?
In this example, you'd be sending the "correct market signal" if you sold your shares as soon as it appreciated to $20. Anything more, and you're moving the market away from its efficient price.
The problem with the squeeze is that certain participants are put into a position where they're being forced to buy. And, that creates an incentive for other shareholders to hold onto their shares well past their fair value. Holding onto shares well past their fair value is antithetical to efficient price discovery.
> In this example, you'd be sending the "correct market signal" if you sold your shares as soon as it appreciated to $20. Anything more, and you're moving the market away from its efficient price.
Is that true? Isn't anything above that price a 'reward' for being correct? And isn't that part of the signal according to a perfect information paradigm?
I don't see how; it creates a disincentive to take short positions which are too low (good for price discovery) and provides a reward for discovering and outing them (good for price discovery).
Assuming the index is priced correctly, the fact that SPY is up 20% means the net present value of future cash flows for the largest companies on the exchange have increased through covid. In and of itself, there’s nothing unethical about that. Unless you’re claiming they’re maliciously profiting off the backs of the unemployed? Would be interested in any evidence of that.
>If I am willing to tie up some money holding an instrument afloat at overvalued prices longer than you are willing to remain in your short position, haven't we ultimately, together in our conflict, created a useful message about the underlying asset?
I'd say it really only sends a message about your assets.
It does reduce prices because it increases the supply of available shares, it's just that reducing prices isn't necessarily a bad thing. We want the prices of bad things (e.g. frauds) to go down and more generally we want prices to reflect reality which happens more effectively when informed investors can express negative views through shorting.
It's worth adding the qualifier that increasing the supply of available shares need not reduce prices at all if there is enough demand to buy shares at the original price (which there should be if the price is definitely correct and the market is efficient enough). Even without perfectly efficient markets the shorters don't make money if enough other market participants think they're wrong
> if there is enough demand to buy shares at the original price (which there should be if the price is definitely correct and the market is efficient enough)
That's true in a weird abstract "perfectly efficient" world where nobody has to buy or sell stocks except for liquidity, and we all just know the correct price.
The normal model of the market posits that different people have different biases and scraps of information, and we use buying and selling to find the "correct" price. Under that model, selling will always reduce the price compared to what it would have been.
The process of shorting involves selling shares now with the intent of buying shares later. Price will drop in the near term bc you're increasing supply. In theory, without short selling, the market would still eventually arrive at the correct price, but short selling expedites the process.
Not all of short selling is bad. Sometimes it's an act of activism. Bill Ackman has been shorting Herbalife for years while trying to expose the pyramid scheme that it is. He was quite successful for a number of years. Similarly, Hindenburg Research, which was shorting Nikola Motors, revealed a lot of fraudulent stuff surrounding Nikola's public statements and their demo truck video.
There's nothing horrible at all about shorting, it's just about investing in the other direction.
It's horrible if funds try to push a company down on that basis, but otherwise it's normal.
It's 'good' because you want people betting on the other side of irrational hubris - if the market is way-overvaluing a stock, you want them to 'lose' and for the stock to come to something within reasons.
Shorting helps prick mini bubbles, or stabilize them, before they start to get way out of hand.
The way I understand it is that short selling is part of a check and balance against companies that you know are lying about their financials. It disincentivizes untruthworthy business practices by incentivizing calling companies out on their untruths.
One example of such a short sell was the report by Hindenburg research about NKLA [0], which also discloses their short position. The net outcome of such disclosures is that fraudulent activity is exposed, the people shorting the stock make a profit, the people who were holding the stock still have their shares, and hopefully new investors are more informed about the stock that's being shorted.
Not all short sellers take this approach though, they could just short the stock because they think it's overvalued. It seems that it's what happened here, but ended up on the wrong side of the trade when WSB decided to buy GME.
In an ideal situation, short sellers are supposed to "keep markets honest".
There are specialized hedge funds that trawl through data to seek out companies that might be engaging in fraudulent activity. They then investigate those leads. If they find evidence of fraud (ie inflated earnings), they short the stock and the make public the evidence.
Obviously the SEC should also be doing this. However, it can be argued that having additional well funded market participants that are financially incentivized to seek out and report fraud is beneficial.
On a side note, some of these hedge funds do not immediately announce which company was the subject of their investigation when they report evidence of fraud. This causes a mad scramble of activity amongst companies that were engaging in fraudulent behavior, resulting in more fraud being exposed.
Is there an equivalent to short selling for physical goods? Does the question even make sense?
If you though gold was overpriced (and there was no gold futures you could short) what would you do? Buy silver? I guess you invent a short by entering a contract to sell someone gold 6 months from now for a given price. But short of inventing a means to short-sell, what would you do?
" I guess you invent a short by entering a contract to sell someone gold 6 months from now for a given price." - i.e. a short futures^H^H^H^H forward contract (oops, futures are on exchanges and forwards not, I forgot that being exchange driven is part of what makes it a future vs. forward)
You could short it like you short a stock - find someone who owns some gold, and have a contract to borrow the gold now, and give it back to them in 6 months, while paying them a small fee while it's outstanding.
Yeah, with fungible items you can easily do it, but you don't because all of them have the natural transformation into pure paper.
For instance, you could borrow a gold ingot and run through the whole thing. But there's no point in that since the validity of the whole thing rests on your creditworthiness and how good that contract is. So you might as well never borrow the real ingot and just write in the rest of the clause of how you are entitled to delivery of the ingot. That way you can trade them.
For shorts to be viable you just need sufficient liquidity that you know you won't fail to deliver on your side of the thing. Which is why fungible goods are easiest.
I am by no means an expert, and have a disdain for short sellers, but I will say this: having watched the "Dirty Money" on Valeance where it appeared that shorts were the first to sniff out the fuckery, I believe we'd need some very strong regulation in place to cover cases like that, which really we should have anyways.
If you're a true "free market" believer, you will probably hold the belief that short-sellers are a part of the "built-in regulation" of the invisible hand. At least that's how I understand the argument.
Really, the biggest problem is that shorts have a vested interest in tearing a company down, be it through tricks like FUD, short ladders or just outright market manipulation. If they're just trying to make sure a stock is not overvalued, fine. If they start trying to kneecap thriving businesses through shady tactics, who does that serve other than the short seller?
"My put contract says that you have to buy my FooBar shares at $X, despite the last sale price being $Y and $X > $Y." I thought that FooBar would drop down to at least $Y, that's why I bought the options contract.
In other words, as long as I have shares to sell, and there's a contract saying that you will buy them from me for a fixed price, then put options could most certainly exist.
without short selling market down moves become more crash-y - short sellers buy (to realize profit) as the stock goes down which tends to support the price. without buyers, an out of favor stock might keep going down in price and have maybe no willing buyers! and that also affects spreads, because market makers hate volatility.
I agree! My opinion is that options market is similar to the derivative market we got into with bundling mortgages up.
Its effectively putting a layer on top of something and the confusion gives those involves in the abstraction ability to make money on top of the real economy.
I'm not a particular fan of short selling, but I can see a definite validity to the value thereof.
What happened here is massive naked short selling, with estimates from 120 to 140 to as high as 200 per cent of available stock shorted.
This is entirely illegal, and has been since 2008, when it was (one of) the contributing factor(s) to that collapse.
However, as per usual, there are loopholes. So the big investors are able to carry on as normal, doing this, and have ways of covering themselves after the fact in a way that protects them from prosecution, while still distorting the market in the very ways that were problematic to begin with.
