An Introduction to Short Selling
March 8, 2019
Short selling is a strategy that is used by a variety of investors, including those responsible for delivering returns to pension funds and charitable organizations. Short selling is used to manage risk, hedge portfolios, and reflect a view that the current market price of a security is above its fair value. This strategy benefits the entire market and the economy at large by promoting liquidity, reducing volatility, and even exposing financial fraud and corruption.
MFA’s short selling white paper provides an in-depth look at the practice, explaining what it is and how, through appropriate regulation, it leads to healthier markets.
How Does Short Selling Benefit Financial Markets?
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.
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 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, the SEC finds 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. Short selling further promotes market stability and transparency by providing valuable indicators of risky, volatile, or overvalued stocks.
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. Short selling indicated the housing market was overvalued and prevented the systemic shock caused by the 2008 crash from being even more widespread. However, the practiced faced widespread backlash and the SEC instituted a temporary ban on short selling. Research published by the New York Federal Reserve found the ban failed to stop free falling price shares and reduced market liquidity.