Does short selling serve any useful purpose in the market?

There are clear detrimental effects to it during the current crisis but what about when markets are stable? Is there any real benefit to the economy or is it just a way of taking side bets for savvy investors and insiders?

There are no detrimental effects. Your economy is fucked because your economy is fucked, it’s not as if AIG and Lehman Brothers were profitable, well-run companies 2 weeks ago, the ability of people to borrow shares to sell short didn’t cause the current crisis.

To, ahem, answer the question :rolleyes:, part of this is that it allows market efficiency by allowing adjustments to overvalued stock. If an investor believes a stock is overvalued but does not already own it, that is the only way for him to take advantage of that belief.

In a downslide like we are experiencing, short selling can not just make an adjustment but contribute to the price slide.

Naked shorts apparently are even worse but I don’t understand enough about economics and the market to explain why they are bad. There has lately been discussion of outright prohibiting naked shorts.

Ordinary short selling is a perfectly sound practice. If one party owns shares that they are willing to lend, and another party wishes to borrow and sell, there is no reason to prevent it. Of course it allows people to bet that the share price will fall–as do put options and even ordinary stock sales. So what? Stocks can’t be fairly priced if people are “required” to believe they can move only in one direction.

Naked shorts are another story. Naked shorting, in which the selling party sells shares that they don’t own and haven’t borrowed, is a form of fraud. The selling party creates shares out of thin air, causing involuntary dilution for existing shareholders. The SEC has rightly banned the practice.

The only way? No. The investor can also buy a put option on that stock or sell an uncovered call.

But if a stock is overvalued shouldn’t the market itself take care of that eventually? I don’t see how an investor taking advantage of, or losing his shirt because of that belief serves any purpose. I’m not moralising here, it just seems that short selling is like making book on professional sports. A way to win or lose some money but irrelevant to the game.

Hmm, well there is one small benefit to the average investor from short selling. A brokerage firm makes money from loaning out shares to be shorted as well as not paying interest on the proceeds received from the short sale until the short position is closed out. So, this should theoretically lead to lower commissions and fees for the average investor at a brokerage firm.

It can also add a floor under a crashing stock price when the shorts cover (buy the shares to give back to the guy they borrowed them from).

Uh, just what do you think the game is?

My apologies, my ignorance is showing. I have heard of puts & calls but never done it and don’t really know how it works.

Whatever game the bookie takes bets on. Sports betting has no effect on the game itself. What I’m trying to understand is if short selling is just a way of taking side bets on the market or if it serves the market itself. Not whether it’s right or wrong, should be allowed or not, just if it facilitates the market in any way.

Exactly. The fundamental misunderstanding here is the nature of “price” itself. The price of any item, be it stocks, houses, dollars or gold bars, is simply a measure of the forces of supply and demand acting upon it. There is nothing intrinsically good about a high price or bad about a low price, at the end of the day it’s just a number on a scoreboard.

Prices matter because they convey information. A high price for something means that more people want it, and thus either more of it will be produced, or in the case of something for which there is only a limited supply, the person willing to forego the most in the form of other things of value (i.e. pay the highest price) gets it. This way, scarce resources such ad oil and skilled labour are efficiently allocated. The difference between us and North Korea is that over here, everyone gets to set the price for everything - there being a (mostly) “free” market, while under a command economy, some guy in an office does it on a whim. Obviously, both theory and empirical experience indicate that we have the right way and North Korea does not.

What is a stock? A fractional ownership stake in a company. Why do you want one? Because if the company you own makes money, it can either pay it back to you in the form of dividends, or re-invest it into the company, so that your fractional stake is worth more. That’s all there is to it. If you don’t believe your CEO will do this, don’t buy the stock. The price of the stock is just what someone else is willing to pay for it right NOW.

So in that sense, why NOT short sell stocks? you are right in the sense that it doesn’t CREATE anything of substance, but then, there ISN’T anything of substance in the price of a stock to begin with - only what the next guy is willing to pay for it. The only purpose of the whole game is information, with which to efficiently organize the economy and allocate scarce resources.

It tells other people in the market that you reckon the share price is going to go down. Whether they adjust their own view to match yours or just laugh at your foolishness then depends on a number of other factors. It’s not just a bet because at some point in time you will need to close your position by delivering the shares you shorted at the price you set, or by paying someone to let you out of your comittment.
Banning shorting seems a dicey proposition to me because it removes a downward force on the market without any counterbalancing check on the bulls - irrational exuberance is what got everyone into this mess and effectively rigging the market to be even more bubbly does not seem wise.

Naked shorting, from what little I know of it, seems more akin to shaking hands to do a deal with the intention that you’ll follow through if it makes you money but if the price doesn’t move in your favour you will just go “hah! I don’t actually have any of those shares at all! Only funning with ya, bye!”. It’s basically a scam that the ever-vigilant guardians of the economy have been 110% okay with for years, but have finally got round to closing down now that they need to be seen to be doing something.

Thanks, that makes sense and puts it in perspective for me.