Questioning The Virtue Of A Short Sale

By Aryeh Katz AAA

From time to time the practice of the short seller comes into focus, and most often the attention it garners is negative. But what is it that the short seller really does? And do we as investors - and even members of society at large - benefit from what many view as his "disreputable" means of earning a living? In this article we'll tackle some of the common questions people have about the virtue of short sales. (For a complete guide to short selling check out the Short Selling Tutorial.)

Information Providers
We take it for granted that someone who has positive information about a company should be permitted to profit from it. So why do we question the short seller profiting from uncovering negative information?

Unless there's a profit motive attached to digging through reams of financial information, no one would do it. The bottom line here is that the market benefits from receiving negative information before it otherwise would have. All investors suffer when stocks exuding a false aura of good financial health are left unidentified. The earlier they are highlighted, the better, and everyone - those who hold the stock and those who don't - should be alerted against holding or increasing their positions.

Liquidity Providers
When buyers want to buy and no one wants to sell, should the short seller be permitted to provide that service? What are the consequences if he doesn't?

The question of liquidity is key to the short sale debate. Buyers who cannot find shares force up prices artificially and widen bid/ask spreads. The result is always a skewed market and erratic pricing. Simply put, when there aren't shares to be had, the short seller fills the void, borrowing now and repaying later - either at a loss or a profit. Remember, short sellers only make money when they're right. They cannot move a market lower if their information is faulty or is presented at the wrong time. It's negative information that causes stock prices to fall. The short seller's activity merely starts that process.

Investment Recommendations
Should Wall Street be granted exclusive rights over investment recommendations, even despite its open conflict of interest with investors (underwriting the same companies that it then researches)? Who should be allowed to issue "sell" recommendations when Wall Street won't?

It's an open secret that brokerages are loath to issue "sell" recommendations against the same companies whose stock and bond issues they underwrite. The underwriting business is far more profitable than retail investment. The problem therefore remains: Who is prepared to say anything negative about a stock before it has already fallen precipitously and "the news is out." Only the short seller, whose unbiased work has to be more detailed than Wall Street's if he's to stand a chance at seeing profits. (Find out more here Analyst Recommendations: Do Sell Ratings Exist?)

Forensic Accountancy
How many investors really know how to read a balance sheet or an earnings report? And should the short seller with superior accounting skills be prohibited from speaking out regarding mismanagement and/or fraud that he uncovers? Should only current stock holders be granted that privilege?

It makes little sense to believe that stockholders will uncover bad information before a short seller would. The average investor is not a particularly gifted accountant. Short sellers, on the other hand - whether they're hedge fund managers, private equity advisors or just astute market players - are some of the best-trained financial minds in the business. Not allowing them to participate is tantamount to restricting the market's ability to utilize all available information.

Industry Insiders
Do we trust industry insiders, who comprise a great number of the short selling cohort, to inform us when key management is leaving a corporation? Or when a new product is about to be launched that will change the industry landscape? Or when cost overruns are plaguing a competitor? Do we not benefit from his contacts and information?

Let's face it: some of the best information on Coca Cola comes to us from Pepsi executives. That's the reality of having long-term industry CFOs and corporate accountants involved in the investment game. They reveal what would otherwise not be known for months, if not years. And they keep Wall Street honest in the process. Bubble pricing is not possible when those "dirty truths" keep getting uncovered.

Legitimate Hedging Practices
Does the short seller have the right to manage risk using long-short portfolio-enhancement strategies, to engage in price arbitrage, or to set up a convertible hedge program for his own or his clients' money?

There are any number of proven and legitimate means of enhancing investment returns and reducing portfolio volatility that involve the shorting of shares (such as the three mentioned above). Try and convince any investor that better returns and reduced volatility are bad for him. (For more on how you can gain from a bear market, check out Inverse ETFs Can Lift A Falling Portfolio.)

Market Makers
Should a floor trader be permitted to short shares in order to remain "delta neutral", and thereby avoid exposing his company or himself to great financial risk?

Delta neutral is a term that describes offsetting trades that result in zero risk (and reward) for an investor. Market makers who provide liquidity must have this option available in order to safeguard their firms' capital. For example, a trader might short sell 100 shares of ABC Co. that he doesn't own to a client to ensure a liquid market. At the same time he will purchase a call option to cover the short should the price of ABC rise. In so doing, he remains delta neutral and hedges against potentially catastrophic loss.

Farmers and Other Producers
Should those who produce the food we eat and the metals and minerals we draw from the earth be permitted to lock in a price for their produce now, even before it has been harvested?

The point here is that short selling occurs wherever people get together to conduct business, and it shouldn't be frowned upon simply because it's done in the capital markets. Short sellers stand to lose just as much in rising markets as longs do in falling markets. Ask any soybean farmer who sold his crop six weeks before harvest - and then watched the price soar by 50% by the time he boarded his tractor. Such are the risks of selling short. (To learn more about futures, see Becoming Fluent In Options On Futures and Grow Your Finances In The Grain Markets.)

Conclusion
Sadly, short sellers often get bad press when the general market is falling and everyone else is losing money. The need for scapegoats is universal, and it's unfortunate when this occurs. It is unfortunate, too, that so many investors are blind to the important service provided by those who risk taking "the other side of the trade."

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