An Introduction to Short Selling

Many investors, including fiduciaries managing others’ assets, use short selling for a variety of reasons, including to manage risk, hedge portfolios, and reflect a view that the current market price of a security is above its fair value. MFA recently released a white paper that provides an in-depth look at the practice, explaining what it is and how, through appropriate regulation, it leads to healthier markets.

Market participants engage in short selling for different reasons, including to manage risk, hedge portfolios, and reflect a view that the current market price of a security is above its fair value.

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How Does Short Selling Benefit Financial Markets?

Price Efficiency

Price efficiency is a measure of how accurately market prices reflect available information. A stock’s price is deemed to be efficient if it accurately reflects market participants’ collective opinion of its fundamental value. An efficient price would reflect both optimistic and pessimistic investor opinions. At the end of the day, short selling allows stock prices to be more accurate.

Market Stability

Markets are more stable when there is ample liquidity. Liquidity is the ability of trades to occur in reasonably large amounts at or near the market price. Short selling promotes market liquidity through different methods. One method is through market makers who fill customer orders for securities. Short selling by market makers helps offset imbalances in the flow of buy and sell orders, when demand would otherwise exceed supply.

Even more importantly, short selling supplies liquidity and reduces volatility when short sellers trade in the opposite direction of price movements. It is a widely held misconception that short selling increases market volatility during times of extreme market stress, leading to accelerated declines in prices. In fact, evidence shows that during a price decline, short sellers will often sell less, or close out their short positions by purchasing shares of the security, which offsets sales by long position holders.

Reducing Price Bubbles

From a long-term perspective, stocks that are overvalued present a problem for the economy. The market will eventually correct the mispricing, but in the meantime, real resources may flow to the overvalued stock or industry. Perhaps the best example was the housing bubble that popped in 2008. Investments in mispriced real estate led to long-term disruptions in the real economy long after the bubble was corrected. Another example was the dot-com bubble, where markets corrected overvalued stocks in a relatively short period of time but firms and employees took much longer to recover.

The absence of short selling in those cases could have made the situation worse. Short selling also helps reduce the risk of future market bubbles.

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