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economics

Why short selling is important

My friend David essentially asked me how short selling could be seen as anything but a greedy gambler’s move. If you’re not familiar with the concept, the idea is pretty simple. We all know you can make money buying low and selling high. “Short” selling does exactly the same thing, but in the opposite order. A short sale starts when you sell something, and then you buy it later at a lower price. This works because the “sale” is really a promise to sell something at a later date. You get the money now, and deliver later.

In recent times, short selling has been demonized and blamed for companies failing. There have been more than a few attempts to outlaw certain forms of short selling. Contrary to popular belief, not all short sales are born of greed, and there is a good argument to allow any type of short selling.

The primary use of short sales in the financial world at large is to hedge against uncertainty and mitigate risk. The classic example is a wheat farmer. Most of us assume that a wheat farmer makes wheat, and then sells it for whatever he can get for it. Things might have worked that way once upon a time, but only a fool would do that on a regular basis these days. A much better way of doing business is to calculate your yield, make a guess at what it will sell for, and then take up a short position a little ways below that.

Why? So you can make plans. If it costs you $30 a bushel to plant and harvest the wheat, you could simply pray that it sells for more than that come harvest time. Of course, if the market dips right then, you’re screwed. A far more prudent thing to do would be to take out options to short wheat at $30 a bushel. That way, if wheat sells for more than $30, you will turn a profit and will lose the premium you paid for the options which is usually fairly low. On the other hand, if it sells for less, you can still sell your harvest for whatever you can get and the options will trigger to make up the difference. You can at least break even.

The same thing can be done for just about any commodity, not just for the producers, but also the consumers. If you are Kellogs or General Mills, locking in a price for wheat will allow you to make all the plans that businesses have to make without the worrying about the vagaries of the market. It can also be done with stocks for funds etc. In all cases, the idea is to mitigate risk at a small cost. Certainly a useful thing.

I think there is an even more important reason for short selling. It’s a little “deeper” and involves economic as opposed to financial reasoning. Marketplaces can be seen as information aggregators. Looking at a share price will tell you a lot about a company. Investors have built into the price both the current, and what they think the future earnings of that company will be. The time to buy a stock is when it’s future is bright and the market has not adjusted to it yet. That isn’t easy to spot, it takes lots of research and more than a little luck to do it consistently.

When not to buy a stock is just as important as when to buy it. People that are shorting the stock believe that the price will go down. That is valuable information. Just as a rising stock price usually means that investors think the company will do well, people that short a stock tell you that someone thinks it isn’t going to do well. Information both good and bad needs to be available to investors in order to make the best decisions.

Most of the companies that screamed bloody murder about short selling were essentially trying to shoot the messenger. They were worried about short sellers “artificially” lowering the value of the stock. In reality, short sellers allow prices to adjust more quickly. If investors overshoot on the way down, there will be money to be had going back up.

Sort selling isn’t really part of our every day life, so it can be a bit bewildering, but it is an important part of well functioning financial markets. The market will give you plenty of information if it is allowed to.

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