Short and Sweet

There is still some confusion over short selling. This confusion leads people to support bans and restrictions on short selling which make very little sense. I think some of the concerns stem from simple misunderstandings and so I’m starting a public education campaign.

The simplest type of short sale is a forward sale agreement. If I enter a contract to sell a bicycle one week in the future I have made a short sale. If I own a bicycle at the time I enter the contract it is a ‘covered’ short sale. If I don’t own a bicycle at the time I enter the contract it is a ‘naked’ short sale.

Almost all commercial contracts involve a short sale because the delivery of goods comes after the contract is entered. Many are naked short sales, usually because the seller needs the cash to pay suppliers before they can provide a product.

From this perspective short sales are not very strange or scary. On the other hand if short sales are ‘selling securities you do not own with the intention to benefit from a fall in the price’ they sound quite strange and dodgy, possibly dangerous.

The confusion comes from convoluted explanations of repurchase agreements. A short seller will borrow a security for an agreed rental rate and immediately sell it for cash. When the time comes to give the security back to the lender he will purchase it at the market price. The lower the price when he repurchases the more money he makes.

Many people feel uncomfortable with this. Part of the discomfort probably stems from the process, which seems a little complicated. Part stems from the fact that it seems a bit dodgy to sell something that someone just lent you. Another part stems from the fact that the short seller wants the price to go down: he desires the misery of others. He might even attempt to manipulate the price downwards to further his evil agenda.

All this silliness can be dissolved by looking at another example of a short sale: a cash loan. If I borrow $10 for a week and use it to buy lunch I am short $10. I have borrowed the cash at a set rental rate, sold it immediately at the market price, and need to repurchase it before the loan is due. It is exactly the same process as short selling a stock, except now it is much less strange and scary.

The effect of short sales is unambiguously positive in terms of market efficiency. Markets work by agglomerating information from many buyers and sellers. Some people think a security is underpriced: they buy it and push the price up. Some people think it is overpriced: they sell (if they own it) or short sell (if they don’t). If short selling is banned a part of the market is not permitted to express their views on the price. The result is biased prices, at least temporarily.

The net effect of bans and restrictions on short sales is not necessarily higher prices. Prices eventually reflect value, even if they are initially imperfect. Market participants might rationally respond to a short selling restriction by selling any stock they own, anticipating the upward bias. The net effect on prices might be up or down, but volatility will certainly increase.

There are also broader issues of property rights and freedom of contract at play. Bans on short sales are enacted by preventing current holders of stock from lending it. The ban lowers the value of their property by denying them a rental income. This is simply an appropriation of property rights without just compensation.

Short sale bans have been popular government reaction to financial crises. Hoover condemned short sellers for their role in the 1929 crash and investigated their role in prolonging the depression. Various restrictions were introduced. In 2007-8 governments around the world responded to a market downturn by banning or heavily regulating short selling.

Short sellers are a convenient scapegoat for a crisis. Restrictions create the appearance of government action during a public panic. A witch is burnt; the villagers are appeased. Nothing changes. When the harvest fails again there will always be someone else to blame.

13 thoughts on “Short and Sweet

  1. The simplest type of short sale is a forward sale agreement. If I enter a contract to sell a bicycle one week in the future I have made a short sale. If I own a bicycle at the time I enter the contract it is a ‘covered’ short sale. If I don’t own a bicycle at the time I enter the contract it is a ‘naked’ short sale.

    I think that is a bad example, because most forward sales are like neither of those. Typically, a farmer might engage to sell a certain amount of wheat at a given future date after the expected harvest. Alternatively, he might engage to sell all or a definite proportion of his crop then, however much that later amounted to. He might – or might not – ask for payment at the time of entering into the contract (if not, he might still use that contract to obtain a bank loan for his immediate needs, e.g. to get the crop in). Throughout, what is sold does not then exist, but throughout actual delivery is covered (unless a fixed amount is committed to but the crop is too poor to reach that – but then there are usually penalty clauses, e.g. to pay a cash penalty and reimburse with interest any cash already advanced, so by meeting those as a fallback the contract itself is not breached).

    A futures contract has many material differences from a forward sale, many of which make a futures contract a better match for describing short selling.

    A distantly related area that also stabilises agricultural returns is the “corn rent”, in which a tenant has to pay some rent in the form of grain at a set contractual price rather than a spot market price, or alternatively pay a proportion of rent indexed to the spot market price of grain, a form of indexing rather than having a set rent that does not risk charging the tenant what he cannot pay (since, wearing his other hat, as well as being a tenant he is also a grain producing farmer).

  2. You’re right about the difference between futures and forwards, I was treating them as the same. But in either case the seller has a covered or uncovered short position prior to delivery.

    I think the cash loan example is the most compelling. It’s difficult to explain repos but everybody understands how a loan works.

    I didn’t know about the corn rent thing — very interesting. Makes sense.

  3. Joseph:

    Governments hate the shorts. It’s very difficult to short a stock in oz now although it’s still fine in the US.

    There are some pretty good ETF’s in the US market that allow you to hop on and quickly hedge up if you think the shot is going to hit the fan.

    I love this one.

    http://www.google.com/finance?q=NYSE:DDM

    this one when there’s big time macro events.

    http://www.google.com/finance?q=NYSE:VXX

    Here’s a list of some 3 X which are really dangerous.

    http://xactronics.com/options-stock-equities-research/3x-ETFS/3x-2x-etfs-etf.html

  4. Some of the full time, big time short players are the most honest players in the market. In some cases they should treated as heroes because they really do allow light in to highlight management and board of directors dishonesty.

  5. Awesome. ETFs are good, even if they are just saving people the trouble of posting margin for futures.

  6. A lot of people I have spoken to over the years just hate anything that is speculation for profit. Even though speculation is central to all economic planning. Converting their thinking whilst possible is typically very painfully slow and they have got to want to change. I do however commend you for trying to explain short selling to a wider audience.

  7. 7 – 5 = 2 ?

    Let him who have understanding reckon the number of the beast, for his number is 2 missing posts.

    I believe that Joeseph has summoned the beast from Gosford.

    I want to see a massive blow up on his blog.

    We only need Bird denounce Steven Kates and every economist in Australia is his enemy.

  8. Is there any decent argument against naked shorting that can’t be made for regular short selling?

    There may be, Jaz, although i don’t really see the problem with it as the shorts are in no way ensured they’re going to make money as people seem to thing they will for some strange reason that I haven’t been able to figure.

    In fact the best and sweetest rides up are picking on heavily shorted stocks and going the other way.. I have a search engine for stocks that allows you to manipulate data to present information like the most heavily shorted stocks in the US. Some of these have well over 50% short interest.

    AIG was such a stock. It went from 7 bucks to 40 bucks in about 15 days as a result of a short squeeze.

    The thing most people don’t realize is that for the past 20 up to 2008 short stocks was pretty much a losing game unless you know what the fuck you’re doing because we essentially had a historic bull-market in stocks.

    Given that you can only make a limited amount of money- zero- the odds don’t really favor short selling vs unlimited upside.

    One of the best ever shorts was the 3 times ETF bank bear index. So many people got on the FAZ mobile shorting the bank index and left all sorts of body parts around. Yo could go the other way and simply buy FAS.

    Faz went from 1040 bucks down to 16 bucks as the US banking system began to ballast itself.

  9. I find the same Terje. If people see goods changing hands they don’t have a problem but they can’t see where the value comes from in purely financial transactions. I think that can change with education.

  10. Short selling should be banned because it sounds like dwarf discrimination! Shorties are being sold because they are favoured (positive discrimination), or disfavoured!

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