Short Selling… Bad or Good? You Decide
Lately, short selling has been a hot topic for investors and the media. As with most hot topics, there are two opposing views. Some industry experts want to point the blame for a significant portion of the market woes we experienced in 2008 and 2009 on short sellers, while others say short sellers play an important role on stabilizing the market.
Short selling is selling a financial instrument, such as company’s stock, that the seller doesn’t own, and therefore has to borrow, at the time of the sale. The investor intends to repurchase the financial instrument at a lower price to make a profit. Buying back the shares they sold is called “covering”. The investor will make money when the value of the stock goes down whereas; they will lose money if the price of the stock increases.
There is a great deal of criticism for short selling for a number of reasons, including:
Snow ball effect: Some short sellers include large institutional investors or hedge funds. The thinking is that if they sell, other investors will see a large sale take place. These investors interpret this as fear over the health of a company which drives them to sell. Other investors see this and continue the sell-off which then drives the price down even further.
Rumors: Since short sellers profit when a stock drops in value, there is a belief that some will create smear campaigns or spread rumors to scare other investors into selling the stock. This will then drive down the value of the stock, which in turn creates a profit for the short seller. There is always the potential for an unethical individual to do this, which makes many critics stereo-type short sellers as unethical rumor mills out for profit.
False Bottom: Remember, when an investor shorts a stock, they are selling borrowed shares. They have to go and buy the shares back at some point. If the value of the stock drops in value, they buy back their shares which could increase the price of the stock. An average investor seeing the value of a stock (that had been dropping in value) stabilize, senses the stock is set to make a rebound when in fact they are buying into a false bottom.
Proponents of short selling see it as an important component to the health of the market. They prefer to point out factors such as:
Over-Under: The practice of shorting a stock helps keep a stock’s price in check for the average investor. If a stock is considered over-valued or overpriced, a short seller can short the stock, which then drives the value of the stock downward – setting the true value of the fund. Once it has hit the appropriate point, the selling and buying will offset each other and stabilize the price.
Hedge: Typically, short selling is used to protect one’s interests rather than as an investment in its own right. This is called hedging and is done to offset exposure to certain risks. Short selling can help prevent the loss of a considerable amount of money on another related investment. Because of this, backers of short selling feel it is an important necessity.
Limited Earnings Potential: Short sellers have an unlimited potential for loss while having a limit on how much they can make. Since a stock can only drop to zero, the amount a short seller can make is limited. However, a stock can skyrocket up to whatever amount someone is willing to pay for it, so the potential for loss is infinite.
As a result of all the turmoil caused with the recent credit crisis and other issues in the market, there have been a number of rule changes dealing with short selling.
From 1938 up till 2007, a rule called the Up-Tick rule was in effect. The rule states, “a listed security may be sold short if the preceding sale of the fund was at the same price or at a higher price.” The uptick rule was designed to make sure short sellers couldn’t dominate trading in a stock to drive its price lower. It was removed in 2007 as a test to see how the market would react. In late 2008, short selling was banned on 799 different financial related stocks because of concerns regarding the financial sector.
More recently, the SEC released five proposals for reinstating the up-tick rule for public comment. The proposals vary from reinstating the up-tick rule as it was to creating new rules that only apply during severe market conditions. A ruling can be expected around the middle of July at the earliest.
With the market down and the turmoil in 2008 some believe that short sellers played a large role in the decline while others feel it only played a small part. There will always be differing opinions on short selling and it will be very interesting to see what new rules will be implemented by the SEC to help govern it.
Jeff Studebaker, Investment Advisor
