There are ongoing discussions concerning short selling of stocks. Those who use short selling extensively, and this includes many hedge fund managers are extremely defensive about the need for short selling. It certainly makes their job easier in the sense it provides a way to guard against downward movements in the market and actually make money while doing so.
The question that I have is has short selling become so commonplace that it has altered the very nature of the stock market? Yes short selling has been around for many years, but the tremendous growth of hedge funds, as opposed to regular mutual funds, and the increased use of short selling via discount brokers has made it a greater factor.
Clearly in a free market you can buy and sell product. It makes sense to buy and sell future promises related to those products in order to reduce risk. However, the idea of selling product that you have never owned becomes somewhat problematic. When short selling and especially "naked" short selling is a small percentage of total transactions it has limited impact. However, as the amount of short sales increase it creates a clear downward pressure on stocks that the short sellers never owned.
When short sellers start to see an opportunity because a stock hits certain indicators or simply because volume of short selling increases enough to get their attention, the number of shares for sale increase tremendously. There can be no counterbalancing group of buyers, except for early short sellers who cover earlier positions to lock in profits. The math on this is clear. For example if there is x stock in circulation, and it achieves a market price based on the number of sellers and buyers, an increase in sellers will cause downward pressure on the stock. For the short sellers who enter the market, there is no comparable group of buyers who can buy stock without actually owning it. Since the stock sold is actually still accounted for in someones account, effectively the number of shares in circulation is increased and the value receives downward pressure.
Yes, all short sellers must at some point cover their positions and effectively remove the fictitious stock from circulation. This theoretically will return the stock to its prior starting point, assuming the volatility hasn't scared of real investors.
Now, short sellers like to argue that they help to expose weak stocks. Not sure who asked them to do that and further, curious as to whether those stocks were that weak before the short sellers started a selling panic. Recently we saw shares of AIG hammered. Now, long term investors in AIG were punished as millions of shares of AIG stock were sold by people who had never owned it. It was such an obvious and easy target that the stock after undergoing a 1 to 20 stock split quickly lost 50 % of its value. Now when it was selling at penny stock levels, it wasn't that attractive a short selling target because there is a point when even a weak stock like AIG appeals to bottom feeders. Once the reverse split went into effect, short interest rose 14.5 percent in the company. About 262 million of the company's shares were held short, just below 10 percent of its shares outstanding on June 30, the day the company approved a 1-for-20 reverse split that was effective July 1.
After the stock plummeted, short interest declined as profit was taken and the stock had a modest rebound, with short interest down to about 8.5%. Now is AIG a bad company with a bad stock? I think that the answer to that is yes. However without short sellers how would the stock have behaved? For those investors holding the stock, many of them still holding on to it from earlier times when it was quite high, the likelihood that they would sell now was slim. There are no institutional holders of the stock so all the stock is actually held either by company employees or private investors, hoping for some eventual recovery. So the only real sellers would be that group of short sellers, that sold nearly 10% of the stock into a non receptive market.
What legitimate investment purpose was served by this? Yes, a number of short sellers made a lot of money and a lot of investors watched their holdings go artificially lower. As AIG has rebounded a bit, short sellers are going to have to cover positions and it is possible that the stock will return close to the level it had before the assault. Of course as it does rise, short selling will increase again.
Now clearly short selling is gambling. There are other ways to bet on whether stocks go up or down outside of actually owning them i.e. the options market, but when you sell a stock short you actually influence the market to some extent. When 10% of a stock is sold short, it is clearly significant enough to drive prices down. I have a problem with this, especially since the numbers involved have increased to the extent they have.
So should the SEC impose restrictions on short selling? I know free market advocates feel that it is unnecessary. I don't really care if people want to gamble. What strikes me as problematic here is that the gambling gets to influence the outcome. If the gambling was simply a bet on whether the stock would go up or down, i.e. options, it wouldn't directly influence the market. However, if a very large hedge fund wants to manipulate a stock, it can sell a large number of those shares short and in all liklihood drive the prices down somewhat.
So is market manipulation a good thing? For those doing the manipulation it is, but not for everyone else.
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