Is there social value in shorting?

[foomarks]

The value of investing (going long) in a business makes sense to me on a social level: it's people putting faith in other people that they will offer a good business to the market that will help them make a return on their investment. Even more simply put: it's people having faith in other people.

Shorting on the other hand seems to make a mockery of society: it shows the behavior of some people who do not have faith in people.

I think Germany is doing the right thing by banning shorting not only to prevent further liabilities but also to secure faith (even though the press and experts don't seem to think so):

http://www.businessweek.com/news/2010-05-25/german-short-ban-drops-bomb-on-regulators-lawyers-update3-.html

I'd love to know what other people think!

[jayruy]

Seeing shorting as "making a bet against a company" is an accurate, but overly simplistic view of modern financial theory.

Say I want to buy a stock index that includes BP, but don't want to expose myself to their current volatility. I could buy the index and short an equivalent amount of BP to replicate the risk I am looking to take on.

Or maybe I am bullish on BP, but don't feel like I have good knowledge on the Oil&Gas industry. I could buy BP and short a basket of stocks that collectively represented the performance of the industry.

This is what people talk about when they mention "complete markets" - the ability for investors to create any desirable risk profile - insuring themselves against events they deem overly speculative.

When the government bans short selling, it's essentially saying "oops, shit has gotten so bad that everyone insuring themselves would risk the collapse of socially important businesses... we got this one (ie bailouts). don't worry, we'll just take it out of your taxes/currency".

[hga]

Shorting sends information and that has serious utility.

Having faith in all people, all companies, all industries, all technologies (e.g. buggy whips, punched card ADP) is delusional. If you're basing a ban on short sales on that, you're just sweeping problems under the rug, ones which will get worse and eventually bite back.

Question: are you interested in efficient allocation of capital or something else, and if the later, why is that superior?

However, did Germany ban real short selling or naked short selling? I've read one account that it did just the latter (and I for one don't support naked short selling).

[foomarks]

Ahh, ok, so blind speculation about even positive outcomes is dangerous (and I can see how this can be just as abused as shorting). So, I can see why paying attention to who is shorting and why they are shorting it is equally important.

Personally: I'm by no means a financial person — just super curious about the usury and trading world and the recent blow up that occurred.

I'm also super curious to see how economics will change from this point forward.

(That article that I posted says that germany wants to ban naked short selling.)

[hga]

"Blind speculation" on positive outcomes is I'm pretty sure fantastically worse, that's a cause of the worst sort of bubbles, the ones that destroy money wholesale (deflation), with sobering examples like the Great Depression and Japan's two Lost Decades (and counting ... and only WWII broke us out of the Great Depression).

Whereas covered short selling pretty much by definition has limited effects; for the purposes of the below, A > B > C

It works by someone borrowing (I don't remember the details so I'll accept Daniel_Newby's calling it renting) something and selling it at current price B. The short seller hopes that the price drops, so that he can buy it back at price C and make a profit on B - C - transaction costs etc.

One limiting factor is that unlike normal investing there is no theoretical limit to the short seller's losses. If the price goes up, he has to buy it at A and he loses A - B - etc. So you need to exercise greater care in taking a short position.

Short positions must be reported in the US and that sends information to the rest of the market. As Daniel_Newby points out, covered shorts make markets more "efficient", an important term of art and an important goal.

I've never come across a defense of deliberate naked short selling that made sense to me (it can also happen in "oops" situations, or so people say); as far as I can tell the only legitimate debates WRT it is how extensive the non-accidental type is and how hard should the latter be cracked down on.

[SkyMarshal]

The CEO of Overstock.com, Patrick Byrne, has been crusading against Naked Short Selling for most of the past decade, and with good reason. Among other socially undesirable uses, it is used by the mob to make fortunes by destroying small public companies. Everything you could possibly want to know about it here:

http://www.deepcapture.com/

Regular short selling is fine, and provides information, liquidity, a mechanism to enable Put options, and a much-needed reality check to sometimes irrationally exuberant markets.

The difference is that with regular short selling, the stocks you're borrowing to sell and then buy back later (hopefully at a lower price than you sold them) actually exist, and haven't also been simultaneously loaned to other short sellers.

Naked Short Selling is where some nefarious market participants exploit flaws in the DTCC to short sell many times more shares than are available for loan. This creates enormous, artificial downward pressure on the stock price of the company being naked shorted, which can destroy the company and turn its stock into penny stocks, while providing immense profits for the naked short sellers. It should be illegal everywhere.

[srgseg]

If I invest my money in a stock, I'd feel safer if other people in the market had had the opportunity to short the stock prior to my investment.

This is because when someone shorts the stock, this results in a sale of the stock, thus pushing the price of that stock down. Thus when they short, their actions help to prevent the price of that stock increase to a level where it is unreasonably highly priced.

So by preventing the stock price from being unreasonably high, this helps prevent me from investing in the stock at an unfairly high price.

People shorting the stock can cause chaos in certain situations where lots of players are highly leveraged and there is significant counterparty risk (in naked short scenarios). However, I fail to have too much sympathy for highly leveraged players because I want them to get burned by the market so they realise it's an unstable and dangerous situation for them to be participating with unreasonably high leverage.

[joshu]

Does anyone recall the studies about markets or securities where shorts are banned?

I seem to recall that onion commodities cannot be shorted and have a great deal more volatility because of it.

[riffer]

This is the main study on the onion futures question. Just be careful, others subsequently came to more mixed conclusions.

http://chla.library.cornell.edu/cgi/t/text/pageviewer-idx?c=...

[hga]

There have of course been some since the 2008 credit crisis and the various bans on short selling and according to The Wall Street Journal the effects weren't good (but take that with a big grain of salt). The example of commodity onion trading is supposed to be the classic one showing it's a bad idea.

[elecengin]

There is no ban on "shorting" onions specifically - it is just not traded on the futures market at all. Gerald Ford pushed through legislation on behalf of onion farmers in the late 1950s to disallow it on the futures market. It has been an example of extreme market volatility ever since.

[adamtj]

Lets assume there is not just no social value, but a negative social value to shorting. I fail to see how you can make the leap from saying that shorting is bad for society to saying that we should ban shorting. Alcohol is bad for society, we should ban alcohol. Television is bad for society, we should ban television.

In America, it's currently Memorial Day, when we celebrate the people who have fought and died to defend our freedoms -- even freedoms that seem bad. Our soldiers carry our flag into battle and die for our right to burn that flag in protest of their actions.

I hope you aren't an American, given the way you so flippantly propose throwing away freedoms because it might hurt poor little society. "Society" isn't a thing. There are only people. If you propose a change in the laws, then you need to argue about individuals and the liberties they will gain or lose, the freedoms that will be protected or weakened. If you propose throwing away some liberty, you must make a very strong case indeed, as it is much easier to destroy liberty than to win it back.

You are essentially proposing that we take freedom from traders to give security to stakeholders. (Nevermind the fact that stakeholders are often the traders.) That is almost never a win. Without liberty, there is no security. Just ask any slave or dictator's subject.

[jayruy]

"They that can give up essential liberty to obtain a little temporary safety deserve neither liberty or safety." -Ben Franklin

But seriously there's no reason to get so strident about it these days. Because of rational pricing (http://en.wikipedia.org/wiki/Rational_pricing), it's extremely doubtful you could find a single economist at a respectable institution who thinks shorting is bad.

In a sense, it's such a abstract issue that I can never see a politician stirring populist sentiment against the sober advice of economic policy advisors. It's simply a short term fail-safe to give politicians time to act.

[drdave]

I was running money for a socially conscious Catholic hedge fund a few years back (they used monks as traders) and asked this question to the fund manager. Specifically, I wanted to short a 'culture of death' video game company which I thought was overvalued.

The fund policy was to hold no positions in any firm that violated Catholic doctrine in any way.

His response was something like this:

"Shorting and derivatives like options tend to reduce the volatility of an asset and hence, tend to improve the credit rating of the firm. So shorting can actually help a firm receive funding from banks that are reluctant to lend if the stock price is more volatile. That being said, I would not condemn anyone for shorting securities of firms engaged in immoral behavior."

[c1sc0]

First of all, Germany is not banning all forms of shorting, just naked short selling. Even then, banning a type of investment unilaterally has only one effect: driving investors out of germany. In today's connected world, money will always flow to the least taxed location. Regulation is just another kind of tax. We have global markets, but no global government to enforce market regulation. So, in my opinion it doesn't matter whether you think Germany's policy is good or bad: when something is futile, good or bad doesn't matter.

[Daniel_Newby]

Naked shorts are basically selling counterfeit stock and should be banned. If I saw a naked short seller being burned at the stake, I wouldn't even spit on them.

Covered shorts are a way of renting out a long-term investment that you do not need at the moment. Renting out equity means that the arbitrageurs use it to make the market more efficient. This gives a buyer an improved price today and a seller an improved price tomorrow, with the short seller taking a modest cut for the valuable service they have provided. An analogy is separating land rights (long term investment) from mineral rights (consumption good).