An Introduction to Short Selling

 

June 30, 2021

Short selling is important to a variety of market participants. Investors use short positions to express a view that a security, such as a stock, is overvalued or to hedge against risk. Pension funds, mutual funds, and endowments earn returns by lending stocks to short sellers, and market makers facilitate the buying and selling of stocks. Short selling is a big part of the market, accounting for nearly 50 percent of the volume of trading in listed equity shares. Short selling is employed widely. It contributes to overall market quality, dampens volatility, and promotes fraud detection and capital formation.

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.

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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 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.

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