Is short selling evil?
Short selling is, at first blush, a strange way to make (or lose) money in various equity and commodity markets. I say make money, instead of investing, because short selling is very much a short term game, much more like speculation than anything else. A short seller tries to profit by selling a borrowed asset, hoping to eventually buy it back and return it to its owner at a lower price. In effect, a short seller bets that the value of the asset will drop, in contrast with a 'normal' investment where the expectation is that the value of an asset will rise.
The risk/return equation for a short seller is quite different from a typical investment. This is because a borrowed asset must be replaced and there can be no guarantee there will be any sellers of that asset in the future. In theory a short seller has unlimited downside risk, or can lose much, much more than their entire investment. This is in contrast with a typical ('long') investment where the risk, except in unusual circumstances, is limited to the value of the original investment. Similarly, at least in theory, a short seller's upside potential is limited to the original investment (that is, the asset becomes worthless) while the upside on a 'long' investment is unlimited.
While short selling is well known in the stock market, virtually any commodity asset (gold, soy beans, currency) can be sold short either directly or through the use of derivatives, contracts, and other instruments. In general, people tend not to associate bad intent with the sale of commodities, either long or short. Things change when the asset sold short is the stock of a company.
Because a short seller is betting the value of an asset will drop, somebody who sells a company's stock short is betting the stock is overvalued. Furthermore, because of risk (and a variety of other factors) the bet is that it is very much overvalued and that the value will correct sooner, rather than later. Naturally, senior executives of companies, who almost always believe their stock is cheap, don't like short sellers, especially those who tell other people why they think a stock is overvalued.
Short sellers who spread untrue rumors hoping to drive a share price down are clearly operating unethically, and in many cases are breaking the law. On the other hand, critiques of company accounting policies, competitive positioning, and so forth are fair game -- and often enough are closer to the truth than companies want to admit. Nonetheless, until (and unless) the situation unfolds for the worse, short sellers are often viewed as cynical non-believers.
It follows that if short sellers are 'bad,' then selling short is wrong. Short selling has been blamed for everything from the Great Crash of '29 to the collapse of Asian currencies in late 1997. Presumably, according to critics of short sellers, a poorly regulated, highly speculative stock market (in the first case) and inept economic management (in the other) were just coincidental.
In reality, short selling a stock is very much like buying a stock using borrowed money. In other words a borrowed asset is exchanged for another asset. In fact, in any economic transaction an asset of lower perceived value is exchanged for one of higher perceived value. Long or short, the risks can be substantial, as can be the profits. The difference is that investing with other people's money doesn't usually carry a stigma. In either case, short selling, or any other investment involving borrowed assets, is a high risk strategy best suited for people who understand (and can afford) the risks. Good and bad have nothing to do with it.
Brian Piccioni is a high tech equity analyst and VP at Nesbitt Burns, a job for which he trained by developing software and designing computers. He lives just far enough out to think of himself as rural, but commutes daily to the city and may be reached there by phone at 416-359-5761, by fax at 416-359-5356 and by e-mail at Brian.Piccioni@nesbittburns.com.
Brian Piccioni
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