The recent scary share price fall in HBOS, the UK banking group, prompted alarm that hedge funds and other naughty speculators were deliberately bad-mouthing the company in order to make its shares drop, and profit from that fall. There may be some truth in this: the UK financial regulator, the Financial Services Authority, is checking this case, although my confidence that the FSA will find anything has not been improved by the watchdog’s almost total uselessness over the Northern Rock affair. But as this article points out, the supposedly demonic practice of “shorting” a company is often a good thing. If investors can make a profit by a company they think is headed for trouble, it can light a fire under the complacent/useless/criminal/other executives of that company.
It all sounds a bit like witchcraft to the economic non-expert. What the bejeesus is shorting? Simply, it is the practice of borrowing something like a company’s shares in the expectation they will fall in price, then selling them, repurchasing them at a cheaper price a couple of days later, and pocketing the difference. Short-selling used to be mainly done by hedge funds who borrowed shares, bonds and other things from banks. But through derivatives like spread-betting accounts, contracts for difference and warrants, even your average Joe Punter can do this, although they would be wise to realise the risks. Numero Uno risk is that the market will not fall as the punter expects, so the investor, be he Nobel Prize winner or retired executive trading stocks in Surrey, should limit their losses by buying a pre-arranged clause to close off a bet.
Making money when a market falls. How cool is that?
So long buying would be called ‘longing’?:-)
In the US there have been companies which have tried suing short-sellers alleging manipulation etc.etc. There has also been a study done (sorry I can’t provide a reference) showing that the stock of such companies severely underperformed the market. During the dotcom. bubble there were many intrinsically worthless companies which attracted short-sellers who usually got creamed good and proper. They were right-except their timing was wrong.So they were not right except after they covered their positions.Lot of good that did them.
Thank God you explained the voodoo practice of “shorting”! Keep it up please, and don’t, whatever you do, start stating the blindingly fucking obvious.
I shorted Goldman Sachs yesterday and covered today for a small profit. Shorting often gets a bad rap, but shorts also help to stabilize down markets because when the market is plunging severely the only folks willing to buy share will be the shorts.
Which part of that was blinding obvious?
I suspect that there are only two people I know offline who could give you a coherent explanation of ‘shorting’ and both of them work in finance.
There has been an interesting development in this area with respect to “shorting” broader market indexes (nobody says Idices except for Sciences).
Securites (ETFs – Exchange Traded Funds) have been formed in which the Fund invests in securities whose price movements are selected with objective of matching the inverse of an index, such as the S&O 500 or S&P 100. Some even shoot for a double of such moves.
So, if one expects (or is willing to speculate) that the index will fall, you buy that ETF.
This can also be done with respect to some sectors of businesses.
However, unless one is a “Big Player,” it is difficult to short an ETF because of the fees and costs of borrowing the shares, if in fact one can find a lender.
A helpful caution: There is no limit to the amount of loss that can be accumulated in shorting an individual security. The loss increases as far as the price may rise.
But then, Life itself is a “short.”
Making money when a market falls. How cool is that?
It’s zero-sum, tho, since shorting in practice is also short-term. In contrast, going long for the long-term is investing instead of speculating, and can result in actual growth; i.e. a bigger pie.
Some short-selling is undoubtedly a good thing – the example given by a previous commenter about shorts stabilizing the mkt is a fine one – but most peoples’ overall preference for going long is fortuitous, IMHO.
I suspect that the correct level of shorting activity is self-regulating by its zero-sum nature. Too many shorters yesterday means too many losers today means fewer shorters with the money/inclination to play tomorrow.
Not really. When someone uses shorting to manage risk (particularly when shorting a commodity, as physical producers tend to, but any investment can use similar logic: I have seen people Short or use Put Options to manage long term stock investments), that is not zero-sum, it is a net benefit to the person whose risk is being managed. And without speculators to provide the liquidity the physical producers/long term investors need, that net benefit cannot be gained. So not zero-sum at all.
Perry,
I can partly agree that it’s not zero-sum to a single player – in your example, “the person whose risk is being managed” – but it is nonetheless zero-sum across all players, which is how zero-sum is normally defined.
You could bet me $50.00 that your home team will beat mine in a sporting match and win. That’s not zero sum to you (don’t quaff it all in one place!), nor to me, but it is to us.
And without speculators to provide the liquidity the physical producers/long term investors need, that net benefit cannot be gained.
Speculators do indeed serve an important role – and far more efficiently than any govt pricing board ever could – by spreading the risk. But spreading the risk is still zero-sum, which in this case is a good thing. Like insurance in general, zero-sum can be a desirable approach at times.
“Zero-sum” is a valid concept, and I maintain that it applies to shorting stocks, even if the z-s itself term is inappropriately applied by Lefties to all sorts of other scenarios where it doesn’t belong, such as their view of an overall economy. Such is not the case here.
But that is why I am disagreeing because ain’t necessarily so. The position may move ‘against’ the person shorting, so if it is simply a speculation, he is a loser and gets no value… but if he is hedging against a long term investment or a commodity future that he will run to physical, he still ‘wins’ (as in he gets value by having locked in an acceptable return at some previous market level using the short position).. and the person who made the market for the hedger also ‘wins’ in that the short went his way… ergo it is not necessarily a zero-sum as both extracted value, just in different terms because their objectives were different (I used to make my living many moons ago broking exactly such things).
So, if it’s not zero sum and everybody wins, where did the profit come from?
The profit is not how gain is necessarily measured – it’s really a question of risk management. Think of it in terms of buying an insurance policy. People are happy to take a probable small loss to prevent any chance of a large one.
While it is true that the exchanges between the insurer and the insured are usually zero sum (each one tries to extract as much money as they can from the other while paying as little as possible), each one is still satisfying their own desires as well as they possibly can, and in a way that they could not do without entering into the exchange. The insured person values the security of mind that comes with insurance more than the premium they must pay for it. The insurer, based on actuarial and other considerations, prefers the premium and the associated risk of paying out to neither of these things. In that sense the exchange is not zero-sum.
Tihs is an example of how the market confuses people. When one is merely observing participants without understanding their subjective valuations, their actions can be inexplicable, and the entire system looks chaotic. But as a participant each person is free to make their own decision based on their own valuations, even entering into complicated financial transactions which make sense to nobody except themselves and their trading partner.
Will it help to point out there are differences in selling commodity-type futures for commodities which one does not own or produce, and selling securities which one does not own?
However, there are similarities as well. By and large, [over-simplified] securities are priced on expectations of (a) future earnings of the entity; or (b) expecations of future desires of others to participate in those future earnings; or (c) some combination of (a) & (b).
In the case of commodities, the continuing production and consumption differ from specific securities which are in fixed supply (at least for some period).
The role of “shorting” is part of the total pricing process by which the information that is scattered over many individuals is conveyed by prices in an exchange (not a true “market” since no goods or services are there exchanged – regardless of the popular label. Financial assets are exchanged for financial assets [swaps anyone?]).
Comparisons of commodities dealings to securities have an analogy in the pricing mechanisms, but less so in the demand and supply for specific forms of financial assets vs the same factors in commodity dealings.
Hope that does not upset anyone.
I don’t think that I really disagree with RAS that shorting any particular stock or commodity is a zero-sum game when measured in purely monetary terms, but there are other societal benefits which accrue from the practice. Not the least of these are the injection of liquidity into the market and the implicit price support it provides, as have already been mentioned here. Another is extracting some amount of risk (or “beta”) from the market and concentrating it in the speculators’ hands, which results in smaller short-term price fluctuations and a more orderly market. Yet another is the signal it sends to management: the total short interest in a company is public information, and an increasing level of short interest can be a leading indicator that people are growing more pessimistic about the company’s long-term performance even if the stock price is still holding up. Managements do pay attention to this.
Short selling is necessarily a short-term activity because over time the markets move inexorably upward (you can’t find a single ten-year period over the last century where market indices weren’t higher at the end than at the beginning), and also because whenever the company declares a dividend the short seller has to pay that amount to the purchaser of the stock he borrowed. This is an incentive for companies to pay dividends (short sellers have an easier time of it with stocks of growth companies that don’t pay them), which I think is generally a good thing.
Thank you Laird. Yes, I was indeed referring to zero-sum in purely monetary terms.
Of course – as you & I and others have noted above – there are other, non-monetary benefits to shorting, but I think it inapt to include them as part of the definition of
“zero-sum” in this case; that would be analogous to the common abuse of the word “equitable” as an excuse to compare apples and oranges.
Indeed, if we were to allow such definitions, nothing could ever again be properly described as either zero-sum or non-zero-sum; all such references would forever degrade into empty arguments about equitability and equivalence across unlike classes.
Fair point, RAS.
Still, I think we’ve gotten a little off-topic with this discussion of Z-S. The focus of the posted article was the confusion (conflation?) of short-selling with market manipulation, and I think we’re all agreed that there is no necessary relationship between the two. Indeed, one can manipulate (or attempt to manipulate) markets whether one is long or short. It’s just that few people really understand shorting, so their default assumption is that it’s evil.
No, the issue is not “market” (exchange mechanism)manipulation. It is the possibility of manipulation of prices of a specific security.
This has been done with great success by Soros in specific currencies, but not in the total currencies markets (exchanges).
As to the effects of “shorting” a stock: What the short does is increase the supply of a limited number of available shares to those desiring to to “invest “long” (however long may be). The lender of the shares for shorting, remains long. Any losers, if the short is right (prices decline further) are those whose expectations were wrongly informed, or who did not recognize the source of the supply of shares (which in the U.S. is published as the “short” position).
When the short is wrongly informed, the loss falls there, in creating supply for which there was more than adequate demand – for which point and figure analysis may stand as a beacon.
I was with you right up until the last clause. Where did “point and figure analysis” come from? That’s the stock market version of astrology: often recognizable only in retrospect, and predictive only because it becomes a self-fulfilling prophecy if enough people read the entrails the same way.
(And anyway, I was speaking about manipulating the market for a specific security, not the stock market as a whole.)
Laird,
The reference to P&F was mainly to show that there are statistics which can inform one about the demand and supply for a specific security.
If it is “Astrology,” then it must be a precurser to Astronomy and celestial navigation. By itself P&F is only a beacon. Certainly one needs to have other information (just as a seaman would refer to his charts for the service of the beacon).
One would be foolish to expect any particular bit of information to be “predictive” per se; indicative, possibly – as are “trends,” “resistance levels,” and a host of other references.
Even Black-Scholes did not “work” in every event.
But, P&F is informative when presented with transaction volumes (sort of the pulse code of the beacon – to use radio-nav.), and checked against short position changes. It may be most helpful in setting “stop-loss” prices, important to shorts.
Oh come off it, I know loads of intelligent people who are baffled by the strategies of investment and who, as a result, endow the likes of hedge funds with demonic powers. By demystifying these practices, we can also remove some of the hype and understand the issues.
Anyway, Stuart A, I have had a look at your blog: the usual boilerploite hard-left stuff with a lot of rudeness and bad-tempered invective. I did not linger.
Hmmm, ras, I must politely disagree on the zero-sum nature of shorting. Using your example to Perry with a bet on a football game, the bet itself is zero-sum in currency terms, but it can result in a more attractive risk/return profile for both your and Perry’s portfolios, i.e higher Sharpe or Treynor ratios for both of you. The same applies to shorting.
Making money when the market falls is cool. Making money when the market rises, and knowing that short-sellers are suffering greatly, is even cooler. Not that I am bitter.
Ah Kepple –
To quote (if not accurately) Buffett:
Be fearful when others are greedy (buying into rising prices)
Be greedy when others are fearful (selling like crazy).
Shorters (your correspondent on occassion) have been, and usually are, greedy in times of fear.