I’ve heard that short selling can drive down the price of a stock. How is this? I’d like an answer that’s more precise than saying there’s a pile on.
Even if the stock price goes down, can’t most companies rely on cashflow and other financing means (e.g.: commercial paper)?
If you understand how demand for stocks can drive up their price, then you also understand how shorting can drive down the price. It’s a perfectly accurate explanation that requires no additional precision.
Well, yeah, if they have cashflow and are credit-worthy. Stocks that are being shorted into the ground often don’t have this luxury.
As to the question you actually asked in the OP, how is short selling “harmful”… first we’d have to establish that it is in fact harmful, and then talk about why. Is it really harmful? There are some shorting practices that are considered abusive (naked shorting and coordinated shorting campaigns, which are both illegal), but on the other hand there are also ways to artificially and illegally inflate stock prices as well. Shorting is not especially fraudulent. Fraud is fraud whether the security goes up or down.
Another view of harm is that the momentum of shorting puts the nail into the coffin of companies that are already headed toward insolvency, depriving them of resources that might help them lead a last-ditch effort toward restabilization. Yeah, maybe, but on the other hand maybe not. A company that is trying to stage a big turnaround at pennies a share generally isn’t ever going to become a good long-term investment. Shorting just helps the market realize this fact and reallocate those assets toward better investments.
I wouldn’t deny that there is definitely an aura of negativity and sleaze around shorting… it capitalizes on the natural tendency of securities to go down faster than they go up. It leads those with short positions to publicly bash their targets (in the same way that long positions are hyped by their holders). It’s easier to coordinate a shorting campaign because it capitalizes on volatility, and because it’s easier people assume that a pile-on is occurring. Some companies have been accused of shorting the same shares that they were selling long to their clients, which is incredibly sleazy and (i think) illegal. Shorting is accompanied by sob stories like people losing their jobs, legal actions, and law violations as companies do anything to stay afloat. It seems sleazy to make money off these depressing occurrences. People look for someone to blame and the shorts are always the easiest target. But that doesn’t mean it’s always fraudulent or harmful.
Yes, more being offered than demanded reduces the price.
But is short selling any more price reducing than normal selling? That is, is there something about short selling that reduces the price more than selling because you want to cash out or because you’re afraid the price will keep going down?
I don’t see any reasonable way this could be true. It seems like that because price drops are usually more dramatic than increases, and it seems even more sour when some people profit off of that, but it’s just another form of selling.
not an expert by any means, but I don’t see how short-selling itself can drive down the price of a stock. In fact, it would seem to act to increase the price. After all it is guarranteed demand. If I short 100 shares of XYZ Corp., then no matter what there is going to be a demand (me) for purchasing 100 shares of XYZ next week. If the company is heavily shorted, say because people are betting on bad news, doesn’t that act as a prop to the price? If XYZ is shorted and I actually own XYZ shares, it might take a premium for me to sell to the people who have to buy regardless of the price.
Of course people only short stocks that they believe will fall in price, so it is a good indicator of future price movement, but in and of itself it seems like it is a prop to the stock, not a weight.
Usually a company whose shares are tanking has other problems. Shares are a cheap source of extra funds, a company does not have to do anything (except piss off existing shareholders) by diluting its ownership with new shares. When there’s a bad market for these, there’s usually a reason. That reason also makes it difficult for the company to sell bonds or get a bank loan.
Shorting shares basically says “here’s someone who’s put his money where his mouth is and says this is what the share price will be in X weeks.” A sufficient volume of that behaviour has to make even experienced investors nervous - “what do they know that I don’t?” Like a run on a bank, it can lead to an irrational frenzy of price drops, where prices collapse as people try to cut their losses in anticipation of possible bigger losses. Not that it happens nowadays, eh?
Considering that most company presidents are usually paid in options on shares offered at or below market value, a dropping share price will be most devastating for the executives who got the company to that position. Can we spare a few tears commiserating on the yatchs and Mercedes that now will never be?
It isn’t. Shorting (and speculation in general) provides the transactional activity you need for robust markets and asset liquidity. Furthermore, buyers do not typically know a seller’s motivation for selling nor whether the stock being sold is part of a short sale or not.
Some people think it’s morally bad because you sell something hoping that it’s price will drop (which incidentally works to the detriment of your buyer) or because it’s not in keeping with the boundless optimism of the American spirit, etc. etc. These people don’t understand stock markets and probably should just stick to CDs.
I think you’re a bit confused by what a stock price is. If a stock price is $10, that means that people are buying shares for $10 and people are selling shares for $10 (i.e. there’s “guaranteed demand” for a transaction at $10).
If I now try to short a stock with an offer to sell at $11, no one will accept that trade – they’ll go to someone selling at $10 instead. But if I offer to sell at $9, people will certainly buy from me instead of the $10 guy. Now we have people buying and selling shares at $9, so the stock price drops to $9.
Generally I agree with you, but there is an element to short selling that can cause spiralling downward pricing, especially because of asymmetries in information.
When there is large scale shorting activity, it sends an important message about confidence in the stock (or lack thereof). It can often lead to stop-loss orders being triggered, further increasing the supply on the market.
Now this can obviously happen with any selling. However, short selling exposes the seller to unlimited risk. Selling a stock I already own exposes me only to removal of potential upside. The message of major short selling to the rest of the market is someone, somewhere, has pretty good information the stock is going down. You need to be more certain of a negative move to short sell than you do to sell stock you own.
Short selling does not help stock because of increased demand. Remember, when the short sale happens - it’s a sale with a future buyback. So yes, it creates a need to cover the position later - but a sale has already occured. The desire for people to sell the stock, manifested in an actual sale, is what drives the price down. People who short are committing to buying back later, but are planning to do so at a lower price.
Think of it the other way - whenever you go long, you’re buying the stock with the intention of selling it later. (Almost) no stock gets held forever. But that intention to sell doesn’t matter - it’s the ‘bet’ that it will go up that matters. When you short, you’re betting that the stock will go down, and that’s what matters.
The consensus opinion of the value of the stock is the value of the stock - and both shorts and longs are indicators of where that consensus is heading.
There is one major thing to remember in all this. Shorting stock – indeed the price of the stock as reflected in the stock market – doesn’t usually have much direct affect on the company. Stock market transactions are between two other parties and determine how much they are willing to pay to have partial ownership of an existing corporation. No money involved in the sale of stock on the stock exchange goes to the underlying company on either a sale or purchase (unless the company happens to be one of the parties involved because they are selling some shares they hold as Treasury stock or buying more).
That means the stock price you see has no direct affect on the profitability or survivablility of the company. It can of course have indirect effects by convincing banks or others to lend to them or not or convincing others to do business with them.
So what is the stock price? When markets are working correctly it is a pooling together of investors opinions to determine what they as a group think the company is worth. Suppose there are three shares outstanding and five investors who think the company is worth $9, $10, $11, $12 and $13 a share. In the simplest case the three most optimistic investors will own the stock and you’ll see it selling at $10 bid $11 ask. (Yes one of the investors might own two shares but to keep it simple we’ll suppose no one wants to own more than a single share in order to diversify.) Note that the $9 opinion does not affect the price at all and were that investor absent (or had an opinion of $9.99 or $5), the market price would still be $10 bid 11 ask. So without short sales this investor’s opinion does not matter.
If we allow short sales, then this pessimistic investor can borrow a share and offer to sell it at any price above $9. The investor who thinks it’s worth $10 would be willing to buy it. Now we will see a $10 asking price in the market as that is the price at which this investor would be willing to sell the share he just bought. The bid would be $9 because that is the price at which the short seller would be willing to repurchase and cover his short.
So allowing short selling does tend to depress market prices, but there’s nothing wrong or evil about this. All it does is permit those with feelings more pessimistic than average to express them and not have their opinions completely shut out in helping to determine the market price.
In fact, a large number of existing short positions can keep share price UP in the short term. The phenomenon is called a “short squeeze”. Let’s say we have some company widely believed to be overpriced, so that everybody and his brother has been shorting it, even though it hasn’t taken the dump everybody has been expecting for weeks or months. The price finally DOES take a significant drop, and all these shorts say “Finally, it’s about $!**&# time”. They all rush to buy shares to cover their short positions, and drive the price right back up again. This is why conventional wisdom says to look at a statistic like “days to cover” before taking out a short position. If it’s 2 weeks to cover, too many people have already shorted it - you’ll be fighting with them to take profits when it drops.
This is not quite true - it affects their market capitalization, which can have very dramatic effects, especially on a financial institution or a heavily leveraged company. A low enough stock price can force pretty much any company into bankruptcy unless their book to market valuation is way out of whack.
Or worse…the company gets some good news and price actually goes up! Now, every short-seller is selling in order to minimize his/her losses. And unlike those who are long on a falling stock, being short on a rising stock has no limit. Being long, the most you can lose is all of your money. Being short, you could theoretically lose all your money plus a whole lot more.
Is there any difference in harm (if any) between short selling and naked short selling?
If I short sell a stock to John for which he pays 100$ to be delivered on August 1 2010. Up to August 1 2010, it doesn’t dip below 100$ but rather goes to 120$ on that day*. I don’t buy the share and I’m in breach of contract. Do I owe him precisely 120$?
*I’m not sure how the day’s price would be determined considering the variation within a day.
Thanks!