Short
Shorting is a specialized finance term. It is also known as going short or short selling. These terms refer to the selling of the instrument or securities borrowed from the third party. Such third party is generally a broker. The main motive behind short selling is to buy the matching assets at a later stage and then to return them to the lender. Short selling works on the principle of selling higher now and buying it back at a lower price later on. A short seller bets on the chances of decrease in the price of the asset. Short selling may result into a loss if asset price rises subsequent to selling and the seller has to purchase it back at a higher price to return it to the lender. Short selling may also involve various other costs such as fees incurred for temporarily acquiring the assets. Other related costs are the payment of dividends for the borrowed securities.
These terms may also refer to derivative contract or other contracts where the investors stand to derive profit from the decline in the price of the asset. In mathematical terms, short selling means purchasing a negative quantity of the assets.
Generally, short selling takes place in case of the assets exchanged in financial markets, securities markets, commodities market or currency exchanges. In such markets, latest prices can be monitored for real time calculation of profits made or loss incurred. It is also easier to borrow such assets and to buy them back. These assets are also interchangeable and therefore are easier to be borrowed and returned. Short selling is exact opposite of the most general form of transactions i.e. going long. Under long transactions, assets are purchased first and the investor gains from the rise in the value of the assets. Short selling relies on the assumption that the seller will be able to buy the identical asset at a lower price point.
In order to short sell, the investor needs to borrow the asset or security. Short seller is then required to buy the similar asset at lower price in order to pay it back to the lender. It is up to the short sellers discretion to decide at which price point to buy the asset back. In some cases, short seller is forced to buy the asset back on the call made by the lender.
The concept of short selling is based on fungibility. It is assumed that a similar asset can satisfy the lender’s claim. Generally, a broker acts a lender of securities or assets to a short seller. Broker, in turn, generally borrows the instrument from some another investor and thus acts as a middleman. The instances of a broker buying the asset for the purpose of lending are rare. The actual investor still can sell their instrument while it is being lent out by the broker. This again becomes possible due to the fungibility of the securities. Broker typically owns a large number of such interchangeable securities on behalf of several investors. These securities can be easily swapped for each other. Under regular market conditions, mutual funds, pension funds and sundry investors provide readymade supply stream of such assets.
The operation of repurchasing the securities for the purpose of returning them back is known as “covering the position” or “covering the short”. A short seller can cover the position any time prior to the due date for the return of the asset. Any price fluctuation subsequent to the covering of the position does not affect the profit or loss of the short seller.
The term shorting may also be employed as a blanket term to denote any activity where decline in the price of the asset benefits the investor. Such activities are generally carried out in derivatives markets such as futures, options and other synthetic products. A put option denotes the right of the investor to sell a security at the agreed strike price. The investor benefits if the price of the security falls below the strike price. Such situation allows the investor to repurchase the security at lower price.
Future contract may also provide similar opportunity if investor short the contract. A short future contract means that the investor is obliged to sell the asset at a later stage for the given price. The short investor gains if the price of the asset falls, making it possible for the investor to repurchase the stock at lower price. Similar situation can be reenacted for other synthetic securities as well to mimic the same results.
Short selling may or may not lead to profits and in this way acts as a speculative activity. A profitable short sales may be of the following type. A short trader decides to trade in Company B stock, which is currently trading at $5 per share. The trader borrows 200 shares and shorts them to receive $100. Later, the price of the stock drops down to $8 apiece. At this time, the trader buy the stock back by paying $800. The trader returns the stock to the lender. In such cases, the lender is under legal obligation to accept the same number of shares as were lent notwithstanding the fact that the value of the individual share has gone down. On this transaction, short seller makes the gross profit of $200. However, the seller is obliged to pay fee, brokerage and other related charges. The profit on this trade arises out of the higher price received on the selling and the subsequent lower price for obtaining those shares.
An example of a loss making short sales may be illustrated as follows. A trader borrows 200 shares of company A at the prevailing market price of $5 per share. The trader sells them for $1000. Subsequently, the price of the shares rises to $10 per share and the trader is required to return the security according to the timeline. For this purpose, the trader now needs to shell out $2000 to buy the shares and to return them to the lender. The transaction leads to the loss of $1000 plus charges and commissions to be paid. The loss arises due to the difference in the selling price and the subsequent higher buying price for obtaining the security.
Going short is direct opposite of long positions. A short seller is bearish in contrast to long investor exhibiting bullish traits. Short sellers generally trade in the securities which are believed to be overvalued. In contrast, long investors believe the securities to be underpriced and expect the prices to rise in the future. The quantum of profit for long investor depends on the increase in price level. Whereas in case of short seller, the profit arises when price of the security dips down.
Since short selling is opposite to a long contract, most of the attributes are reversed for these positions. In short positions, theoretically, the loss is unlimited whereas profit is limited to the sales price of the security. In order to minimize losses on short transactions, the investor may be called by the broker to either settle the position or pay additional security in case the price of the asset increases beyond a threshold level. This precaution helps to control the amount of loss that any investor may occur on a short position.
Short selling has been prevalent from a long time. According to some documents, the practice started as early as in 1600s and was practiced by a Dutch merchant Isaac Le Maire. He held a major chunk of Vereenigde Oostindische Compagnie stock. Short selling had always been the center of criticism. England placed an outright ban on its practice in 18th century. In June 1772, short selling caused a major panic when it caused mass failure of private banks in Scotland. It also caused liquidity crisis in Amsterdam and London, two major financial hubs. This crisis happened following the collapse of The London Banking house of Neal, James, Fordyce and Down. The bank had built massive short position in East India Company shares and had use customer deposits to mask its losses. The crisis was further deepened due to Dutch tulip market crash.
In 1992, famous investor short sold $10 billion worth of GBPs. The short selling is considered to be reason for “breaking the Bank of England” in 1992. The word ‘short’ is considered to be in use since mid-nineteenth century, if not earlier. It is understood that the short seller hold deficit position and hence the term is employed. The practice of short selling is believed to have been started in the US by Jacob Little. He is also known by the name of “The Great Bear of Wall Street”.
Short Selling has always been notorious. It is supposed to be the major reason behind the Wall Street Crash in 1929. In response to such turmoil, the US implemented various regulations in 1929 and 1940. After 1929 crisis, the Congress enacted a law to place a ban on short sellers from selling stock during a downtick. The rule came to be known as Uptick rule. It remained in force till 2007. In July 3, 2007 the SEC removed the rule via its release number 34-55970. The practice of short selling has been widely condemned by various presidents including J. Edgar Hoover and Herbert Hoover. However, it is the practice of short selling that led to the creation of Hedge funds. Alfred Winslow Jones created a fund to buy stocks and simultaneously sell other stocks. Such practice provided some cushion against market risk. Any news which may affect the stock price negatively may act as a catalyst for short selling.
There are several scenarios which can lead to extreme loss in case of short selling. Such cases arose in the times of dot-com bubble when short seller decided to sell start-up companies’ stock. In some cases, such start up firms were acquired at a far higher prices, causing massive losses to short sellers. Many firms overpaid for such start ups, forcing the short sellers to cover their short positions at a very high price.
Short selling has always been demonized. However, the problems caused by excessive short selling are further augmented by naked short positions. Such positions cause undue market volatility. In September 2008, such transactions were banned by the SEC or the US Securities and Exchange Commission for a period of three weeks. Later, in an interview, SEC Chairman Christopher Cox admitted that the decision to put restrictions on short positions was taken reluctantly. However, he also clarified that Federal Reserve chairman Ben S. Bernanke and Treasury Secretary Henry Paulson were of the view that the ban was necessary to save financial institutes from collapse. They were quoted as saying, “If we did not act, and act at that instant, these financial institutions could fail as a result and there would be nothing left to save.” Cox later changed his views and considered the ban to be ineffective. He questioned the efficacy of ban. According to Cox, the data collected from the temporary ban was still under investigation and no conclusive results were drawn. He also emphasized that it would take a long time to make proper evaluation of the results of the ban. Cox concluded that ideally Commission should not repeat this action. He said, “While the actual effects of this temporary action will not be fully understood for many more months, if not years. Knowing what we know now, I believe on balance the Commission would not do it again.”
US had implemented this ban on 799 financial companies. The ban was implemented to stabilize these firms. UK Financial Services Authority or FSA had implemented the simultaneous ban on 32 financial firms. Australia also levied the ban on September 22. Instead of banning a few firms, Australia put a blanket ban on short selling. On the same day, Spanish market authority CNMV issued the notice to investors to inform regulators about any short position held by them in a financial institution. Such notice was required if short position exceeded 0.25 percent of a firm’s share capital. Spain also put restrictions on naked short selling. In 2010, Germany put a blanket ban on naked shot selling to avert economical crisis. In 2011, Spain, South Korea, Belgium, Italy and France also banned all kinds of short selling in their financial markets.
Short selling follows a set procedure. These transactions are governed by regulations enacted by authorities in their respective countries. For the purpose of short selling, the investor issues instruction to the broker for selling the shares. The proceeds from such sale are credited to the broker’s account. Such proceeds are generally not available to be used for any other transaction. Short seller also does not get paid any interest on the proceeds of such sale. According to the US regulations, the investors have three days to cover their position. The regulators may also require the investor to deposit securities or cash as collateral for the short selling. Such collateral is used for meeting initial margin requirement. Some institutional investors such as hedge funds and financial firms may opt for naked short selling. A short selling is called naked short selling when the shares are neither borrowed nor delivered. The investor is required to cover the position and the price level of the security would determine whether there is a loss or a profit on the transaction. If the price level has dropped below the selling price, the investor would make profit. If the position is inversed, then it would lead to loss. Investor may also choose to carry on its short position or may return securities to the lender.
As explained earlier, different countries have different regulations for short selling. In the US, the short seller needs to engage with a broker-dealer. This is done to ensure that the seller is able to deliver the short sold stock as and when required. The process is called ‘locate’. Brokers use various methods to make the process of ‘locate’ easier and to make delivery of short sold stock.
Loans made by fund management companies and the leading custody banks constitute the major chunk of the stocks to be borrowed by the brokers. Many financial institutes lend out their securities to make extra money on idle assets. Such loans are generally arranged through a custodian holding the assets for various institutions. Under such arrangement of loans, the borrower is required to provide cash collateral security. Such collateral security generally amounts to 102% of the total value of the assets. Such cash collateral security is used for investment purpose by the lender. The lender also gets to keep a part of the interest as the compensation for lending the stock.
Some brokerage firms use their customers’ accounts to borrow stocks. Broking firms carry out agreements with their customers and such agreements give them the right to automatically borrow shares from customers without obtaining specific approval. Normally, brokers only lend shares from the accounts with debit balances. While these brokers can also borrow shares from fully paid up share accounts or from cash accounts, but regulations in such cases are too strict and hence any such borrowing is generally avoided by the brokers. The Securities & Exchange Commission has enacted such regulations under its Rule 15c3-3. Under this rule, the broker is required to obtain specific approval from the client for borrowing the securities. The broker is also required to pay collateral or to issue a letter of credit for this purpose.
In case of retail clients, most brokers allow short trading only if any other of their client has bought the security on margin. The broker is likely to carry out the ‘locate’ procedure outside of their firm only in the case of their institutional clients. Various exchanges provide information about the “short interest” of a stock. Short Interest is that percentage of total float which has been legally short sold. Alternatively, short interest ratio is the number of shares legally short sold as a multiple of the average daily volume. These numbers are useful for the purpose of spotting stock price trends. The investor also needs to take into account the number of shares created by naked short sellers. For every short sold stock, there is a shadow owner or the original owner. Such original owner does not have any voting right but still retains some rights and interests in the stock.
Short selling is closely related to the concept of security lending. When shares are sold, the seller is under obligation to provide delivery of the stock to the buyer. However, in the case of short selling, the seller may need to borrow the stock for the purpose of fulfilling the obligation. Short seller needs to connect to the third parties such as investment management firms or custodians. Such financial institutions charge fee for such lending of securities. In certain cases, even retail investors can charge interest or fee on the securities lent by them to their broker. However, for this purpose they should have proper title over the shares.
Many countries such as Hong Kong, Spain, the UK and the US offer time delayed data about short interest. Due to the emergence of new strategies and structural reasons such as bear ETFs, short ETFs and the proliferation of 130/30 type strategies, the volume of short selling has increased manifold in the past few years. This data is generally not real time. For example, in case of NASDAQ, the exchange collects data from its broker-dealer on 15th of each month. It takes another 8 days to compile and publish this data. Such data is important as it can serve as a proxy for predicting short interest levels. Some data providers such as SunGard Financial Systems provide daily short interest on the basis of lending and borrowing data.
Short selling involves some specific functions and there are specialized terms associated with them. These terms are as follows:
Days to Cover: It is a numerical term used to denote the relationship between the number of shares legally shorted and number of days required to cover them. The number of days are calculated on the basis of average trading volume done on daily basis. E.g. ABC Inc. has one hundred million of its shares legally shorted. On an average basis, ten million ABC stock is traded daily. Therefore, it would take 10 days of regular trading to cover all the legal short stock.
Short Interest: This concept refers to the quantity of the short sold share divided by the total outstanding stock of the company. This concept is usually defined as percentage. We can take example of a hypothetical company with 10 million outstanding shares. If it currently has 1 million shares in legally short category then its short interest stands at 10%. However, this ratio is not reliable if there are naked shorts as well. In such cases, “fails” data should be accessed for determining the true quantity of short interest.
Many banks and financial institutes carry out lending business. Among the prominent lenders are Merrill Lynch, State Street Corporation, JP Morgan Chase and Northern Trust. Apart from these institutes, ABN Amro, Citibank, Bank of New York Mellon Corporation, Barclays and UBS AG also act as lenders.
Naked short selling is a specialized kind of short selling where shares are shorted without actually borrowing them within the stipulated time. This transaction means that the buyer does not buy the actual stock but the promise to convey the stock. Such promise is also called hypothecated share. If holder of such stock receives any dividend then the person holding such hypothecated stock become entitled to receive such dividend from the short seller. Generally, naked short selling is illegal. However, in certain cases, it is permissible by market makers. Naked short selling shows up as ‘fail’ or ‘failure to deliver’ in the database of the Depository Trust & Clearing Corporation. Most of such fails get settled within a short period of time, but a fraction of them are allowed to perpetuate.
Before a short sale is done, it is necessary to borrow the stock. In US, this process is called ‘locate’. IN 2005, the US Securities and Exchange Commission (SEC) enacted Regulation SHO to put a curb on short selling without carrying out the procedure of ‘locate’. In 2008, even more strict regulations were imposed. These rules were put in place to prevent any mass failure to deliver the shares subsequent to short selling. In 2009, these rules were granted permanent status.
There are various fees and charges associated with short selling. A short seller is generally charged a fee by the broker. This fee is generally in the form of a standard commission. A short position may go in favor or against the seller. In case it moves against the seller, then money is transferred from the seller’s account to their margin account. If the position keeps moving in adverse direction and the entire balance in cash account is exhausted then in such a case, the short seller may borrow on margin basis. In such cases, the borrower is required to pay interest charges. These interest charges are calculated like regular margin debit. A short position can only be opened by a margin account.
In case the short security turns ex-dividend then such dividend is reduced from the short seller’s account and is paid to the lender of the stock. Some brokers do not pay any interest to the short seller on the proceeds derived from such short selling. This proceed may be used to lessen outstanding balance in the margin account. However, in most of such cases, brokers choose not to pass such privilege to their retail clients and such arrangements are limited to large and institutional clients only. The interest may also be shared with the stock lender.
Short sold stock also accrues voting rights and dividends. In case the company distributes dividend on the shorted stock, then the dividend is payable to the new purchaser of the shares as such purchaser becomes the holder of the shares in the registers of the company. Since, the stock may have been lent without the express consent of the lender, the dividend is also expected by the lender. In order to solve this problem, short seller pays the equal amount to the lender. Due to this reason, a short seller is also considered to have “short the dividend”.
Similar issue arises when it comes to determining the voting rights. However, voting rights on the shares cannot be artificially replicated the way dividend can be. Since the buyer of the shares is the legal owner of the stock, the voting right rests with the borrower of the stock. It is assumed that the actual owner of the stock holding the shares in margin account had agreed to relinquish their voting rights on the shares so lent to the borrower.
Short sales can also occur in futures as well as options market. In case of futures contracts, a short sales mean that the seller is obliged to make delivery of the concerned goods at the time of expiry of the contract. However, the short seller may also simply buy back the goods before the expiry of the contract. Future contracts in short mode are also used by commodity producers to fix the sale price of their goods before producing them. Short contracts may also be used to hedge long positions. Thus, short positions may be created for speculative purpose or for the purpose of hedging. In case of short position for hedging, the main purpose is to cap the loss. However, in case of speculative short sale, the main idea is to profit from the favorable price movement.
Short sales can also be replicated in the case of option contracts. Buying a put option is essentially like shorting a stock. Options come with certain characteristics which differentiate them from regular short sale. Put option gives the right but not the obligation to sell the securities. Unlike, a short future contract, put option also lets the writer limit their loss. Put option writer may choose to sell the asset at the strike price or not, depending on the current level of prices.
Short selling can be carried out in stocks, commodities or even currency. However, there are some differences in these short contracts. Currency contracts are made in terms of two different currencies, where each currency is valued in terms of another currency. Therefore, shorting in the currency market is akin to regular long contract in stock market. Inexperience traders tend to get confused at this point. A contract is always short for one medium and long for another.
In case of currency short contracts, the trader purchases the first currency when there is change in the exchange rate. For example, A trader wants to trade in Japanese Yen and US Dollar with exchange rate of 80 yen per dollar. The trader borrows 160 yen and buys 2 US dollars. Later, exchange rate changes to 85 yen per dollar. Trader sells 2 US dollars and receives 170 yen, thereby, earning a profit of 10 yen before paying fees and charges. Currency can also be shorted through options or futures contracts.
Short selling contracts carry several risks. This strategy is sometimes known as negative income investment, since this type of investment does not generate any interest income or dividend income potential. Shares are held only for a short time duration and the contract leads to capital gain or loss. Shorting stocks carry very different risk profile from long contracts. Long contracts have limited loss potential capped by the purchase price paid, but short contracts have unlimited loss potential. By the same analogy, long contracts have unlimited theoretical potential for gain. Due to high risk profile, short contracts are generally used as hedging for managing loss on regular long positions. These rules are generally not applicable to currency shorting as the short contracts in currency market are fundamentally different from short contracts on stocks.
There are many strategies for controlling risk in short contracts. Some traders use ‘stop loss’ technique for capping their potential risk. In such cases, short seller instructs broker to cover the short if the price rises beyond a certain point. This strategy helps short seller to limit the loss. In some cases, the broker may also choose to cover the position without express consent from the seller. It happens in the case of extreme price movement in adverse direction. This is done to ensure that the seller is able to fulfill debt obligation.
Another risk faced by short sellers is “short squeeze”. Short Squeeze happens when stock price increases swiftly. In such cases, panic takes over as short sellers clamor to cover their positions. This phenomenon also triggers automated system if the short sellers have entered stop loss orders. These steps are taken to avoid high level of losses. In such cases, short seller may also be forced by brokers to cover their positions. A short seller may also be bound by the terms of contract with the lender to sell the shares in certain cases, if the lender is willing to realize the profit. Short Squeeze leads to high buying pressure and thus may push the prices even higher. Due to this reason, short selling is generally practiced in the case of heavily traded stocks and the short sellers always pay attention to “short interest” levels for the securities involved. Short interest denotes the number of shares legally shorted which are still uncovered. Short Squeeze may happen on its own or maybe induced deliberately. If ultra high net worth investors or institutional investors notice high level of short contract, then they may buy large number of shares with the motive of selling such shares to short sellers who may be baffled by the sudden uptick in stock prices. Other short sellers who may be forced by their brokers to cover their position may also become victim to such short squeeze.
Short seller also faces the risk that the stock may become difficult to borrow. This may happen due to deficiency of availability. Securities and Exchange Commission has defined “hard to borrow”. This definition allows a broker to charge a “hard to borrow” fee on the daily basis. Such fee may be started to be charged without any previous notice. This fee may be charged on the days when SEC declares a stock to be “hard to borrow”. In such cases, a broker may also be forced to cover any short seller’s position on their discretion. The short seller is sent a warning about the failure to deliver the securities.
Short Selling also entails the credit risk for the broker as short seller is under the obligation to deliver the promised stock to the broker but may lack money for purchasing the securities. For mitigating this risk, the broker maintains a margin account and levies interest on the amount lent. This interest rate may vary between 2% to 8%. Regulators have imposed various penalties on the failure to deliver the stock. Noted financier Daniel Drew once said, “He who sells what isn’t his’n, Must buy it back or go to pris’n”.
In 2011, China stock frauds rocked the North American equity markets. In response to such frauds, major stock exchanges such as NYSE and NASDAQ had to impose long trading halts. Such trading stops sustained the price level of shorted stocks at arbitrary high levels. In some cases, brokers chose to charge high interest to their clients on the basis of such inflated values of stock as short sellers were not able to cover their positions due to trading freeze.
Short selling’s impact is further exacerbated by reckless selling. Short sellers also provide price support when negative sentiment prevails in the market due to steep fall. But short selling also has negative implications as it may lead to excessive or unjustifiable fall in share prices.
Short selling also involves use of strategies. Some seller may use this technique for managing losses on their other transactions. For example: a famer may choose to enter into a short future contract to lock in the sale price of their harvest. Similarly, a market maker dealing in bonds may hedge their long position in corporate bonds by shorting government bonds. This way the only risk such market maker has to face is the credit risk. Since such market makers may create large positions in bonds due to frequent trading, they become sensitive to interest rate fluctuation. In such cases, the above strategy of hedging via shorting is helpful. An option trader may also carry out similar transaction to attain delta neutral position. In this way, the price movements do not affect the trader’s position. Thus, short selling can be used as a speculative tool to derive profit from the movement in prices, but at the very same time it can also be used for managing risk profile as a hedging tool.
Short selling is designed to take advantage of price variation in the market. This concept is known as arbitrage. Another strategy related to short selling is “selling short against the box”. This strategy involves buying the stock where shares are already on a high. The trader simultaneously shorts the same quantity of stock. This way trader can lock in the profit on long position. It is also helpful in managing tax position. A short position counterbalances the long position and any further variation in the price level does not cause any change in trader’s position. This way, the trader does not need to carry out the selling immediately and it may be deferred to next tax period.
In the US, there are specific tax regulations for such “selling short against the box” transactions. In general, such transactions are considered to be constructive sale and thus are a taxable event. However, there are certain conditions when the above rule does not apply. These conditions include the event when a short position is closed within 30 days of the year end and that the trader holds their long position without getting into corresponding hedging position. This should remain in force for a minimum period of 60 days after the closing of short position.
US had imposed restrictions on short selling from a long time. Regulation SHO was a major amendment brought to such restrictions in a long time. The regulation brought about new requirements such as “close out” and “locate”. This was done to put a dampener on the practice of naked short selling. These regulations were imposed in 2005. As per the US regulations, IPOs or initial public offerings cannot be shorted within a month of their initial trading. This regulation has been established to stabilize the company’s stock price during the initial period. Some bucket shops or broking houses specializing in penny stocks use this regulation to pump and dump IPOs with lower trading volume. Canada and some other countries do not have any such restriction.
UK restricted short selling of shares of 29 financial companies. The ban was implemented with effect from 2300 GMT on 19th September 2008 and remained effective till 16th January 2009. After the repeal of ban, John McFall, made a public statement revealing that in his view, the ban should have been extended further. He also wrote a letter to the Financial Services Authority stating the similar sentiments. McFall was acting as the chairman of the Treasury Select Committee for House of Commons. Similar ban was imposed by the Securities and Exchange Commission in the United States. The ban was imposed on stocks of 799 financial companies. It was levied on 19th September, 2008 and remained in effect till October 2, 2008. Securities and Exchange Commission also introduced stricter requirements such as mandatory stock delivery at the time of clearing. It also imposed harsher penalties to curb the practice of naked short selling. At the very same time, some US states requested their state pension funds to stay away from shorting major stocks.
Short selling bans have been used by different national authorities at different times to contain the damage which may be caused by reckless short selling. Australian authorities also banned short selling during the period of 19 September, 2008 and 21st September, 2008. The ban was further extended by 28 days. It was a temporary ban, but later Australian authorities imposed indefinite bank on the practice of naked short sale of the stocks. Around the globe, Ireland, Canada, Switzerland and Germany imposed ban on short selling of stocks of major financial companies. The Netherlands, Belgium and France curbed naked short sale of shares of select financial companies. However, Chinese government took the contrasting steps and allowed short selling. It also introduced various other market reforms.
However, later assessment of the efficacy of bans showed that it had “little impact” on the stock movements. It is also believed that the bans actually had negative impact by reducing liquidity and volume. In general, the prices moved with the same intensity which they would have done in case of no ban. The US had lifted the short sales ban in 2008 itself, while European authorities had more or less lifted such bans by December of the same year. However, in April of 2009, the Securities and Exchange Commission had drawn a new set of restrictions to be imposed on the practice of short selling.
There are many views about short selling. There are vociferous critics claiming short selling to be the evil practice of stock market, while the proponents of short selling advocate in its favor. Some proponents state that short selling is an integral part of price discovery system. According to a study conducted by Duke University, that short interest level may be used as a sign of poor share performance in near future. It also revealed that in certain cases short sellers may exploit market inefficiency about any firm’s fundamentals.
However, the practice of short selling has been defended by various prominent investors such as Warren Buffett and Seth Klarman as they insist that short sellers help stabilizing the market. According to Seth Klarman, short sellers tend to normalize extreme exuberance in the form of bullish sentiments widespread on Wall Street. Warren Buffett, on the other hand, claims that short sellers provide useful services for the purpose of revealing fraudulent accounting and other such practices prevailing in a company. Such claims were substantiated when noted short seller James Chanos brought to the light shady accounting methods used by Enron Corp. He also claims that short sellers were instrumental in bringing various other such scams to the light. Short seller also cast a light on the practices undertaken by Boston Market. In 2011, short sellers were able to expose the China stock frauds through their bear sentiment oriented studies and research.
On the other hand, noted commentator Jim Cramer holds critical view of short selling and had launched a petition for the reinstatement of the uptick rule. However, he has been widely criticized for his views. In his book ‘Don’t Blame the Shorts’, Robert Sloan claimed that Jim Cramer has overstated the negatives of short selling and has downplayed various benefits of the practice. He also claimed that short selling is useful in identifying asset bubbles. Similar sentiments were expressed by Robert E Wright in his book Fubarnomics.
Various short sellers have been prosecuted at different times. Manuel P. Asensio was embroiled in a bitter and long legal skirmish with the pharma company Hemispherx Biopharma. Various studies have already shown that short sale bans are generally not effective and do not bring about any marked changes to market dynamics.
Short selling practices have proliferated a lot during the recent times. Despite various bans and curves, the practice is going steady and is providing valuable services. Short selling is important not only as a speculative tool but also as an instrument for hedging. Short contracts can also be used to adjust greeks like delta on various contracts. Short selling can also act as a leveler against extreme bullishness in the market. Various research oriented short sellers have provided valuable services by providing advance warning about malpractices followed by some companies. Short sellers also make markets more balanced by providing critical view of the companies and stock values.