Short selling serves no market function

Can anyone explain to me what constructive function short selling serves in a marketplace?

I can understand the purpose that futures serve - originally created to allow producers to plan and hedge, and speculators are happy to take on that risk and sit on the other side of the trade.

I can understand the purpose of various derivatives, again to serve a hedging purpose and thus provide a useful function for everyone from producers to portfolio managers to investors etc.

But I can not see what function shorting serves.


Also I do not understand how the shorting process can be justified as legitimate trading activity by the markets that allow it.

To short a stock you first need to 'borrow' that stock from another holder.
You then 'sell' that borrowed stock - now in my language if you are selling something that isn't yours then its not yours to sell, so how is this allowed suddenly in the stock market and considered valid. Then to pay back the 'borrow' you close the short position by buying back stock. The flaw is, in theory there would be a situation that you cannot actually return the borrowed stock because there's none left to purchase. Thus the word 'borrow' is a misnomer to my thinking and a better way of expressing it would be that the lender is actually transferring title to the stock with an agreed timeframe for equivalent stock to be transferred back from the borrower.

Consider a company that has three shares on issue. Holder A has 1 share. Holders B and C also have 1 share.

Mr E comes along and borrows Mr A's 1 share and 'short' sells it to Mr C.

In a few days Mr E wants to buy back 1 share to return the 'borrow'. But nobody wants to sell at any price - B and C both steadfastly hold and will not sell at any price. This means Mr E CAN NOT return the 'borrowed' stock. Thats because he actually sold something that wasn't his. So when reduced to fundamentals like this the word 'borrow' is actually technically incorrect. The stock has really been transferred ('sold') with an agreed price and timeframe for it to be returned. (transferred from lender to shorter for $0 with an agreement the lender will transfer equivalent stock back to lender for $0 in an agreed timeframe).

I've asked this question once before on another thread - but where does borrowed stock used by shorters actually come from, and do the holders of that borrowed stock actually know their stock is being loaned for shorting purposes?

Also why would anyone lend their stock to somebody that is going to push the price down? (perhaps because you want to buy more yourself?). What benefit is there in that and shouldn't the lender reap some benefit from this exercise as well?

Well done, and well written.

But I don't know the answer

Good questions and I wont pretend to have all the answers, but have some suggestions.

Shares that are being short sold are borrowed usually from institutions. The instos are paid "interest" on these shares (its not interest, but the concept is the same). So the insto has the stock, gets the dividends etc. and earns extra "interest.

The shares are borrowed without a necessarily fixed time frame for return. They can be called back by the owner of the shares at his or her discretion.

As for its not lending but is transferring of title - I am sure you don't want to get into some semantic or legalistic argument ... and I am not qualified to anyway but if the shares actually have title transferred then doesn't that make the "borrower" the owner and he/she is not actually shorting at all! (There is a broker that arranges shorting in this manner ... again the legals are beyond me).

I like your 3 shareholder model - this is how a 'short squeeze' could play out in the market, sending the price higher. Of course the real world is more complicated and as the price rises it will attract a seller, or sellers, and these sellers will be in competition to get their sale done at a high price, so putting a limit on the price rise.

Do instos know that stock being borrowed from them is being used for shorts? I would be (very) surprised if they didn't, but you'll have to ask them to be sure...

Why would they lend shares to someone who is going to push the price down. Well, there are risks to the short seller (maybe lowish in the current climate!). But a short seller becomes a potential buyer too, and yes, maybe if the price does fall the insto will be happy to buy more (might create a bit of short squeeze as a side benefit, too).

Short selling can be used in conjunction with option strategies too.

Timmy said:

Short selling can be used in conjunction with option strategies too.

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Bingo! If you want a market function, option traders need to be able to sell short in order to hedge. Without this capability, you say goodbye to option liquidity as market makers could not operate.

See the explanation in Wikipedia:

http://en.wikipedia.org/wiki/Short_selling

This sets it out clearly.

So when the market crashes there is someone there to buy it off the panicking bulls that bought it at too high a price.

cuttlefish said:

Can anyone explain to me what constructive function short selling serves in a marketplace?

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I don't have the answers. I've played the short side of the market many times, in fact I'm doing so right now in this bear market, and loving it. But I've only done it with CFD's or options, never with stocks themselves.

I don't have any figures, but I reckon these days that many short sellers would be using derivatives to do it.

Bunyip

thanks for the informative responses all.

Trembling hand said:

So when the market crashes there is someone there to buy it off the panicking bulls that bought it at too high a price.

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lol

battiwallah said:

See the explanation in Wikipedia:

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cheers.

The wikipedia article states: While the shares are lent, two investors have a right to sell the same shares. If this is true then to my mind it highlights how ludicrous the concept of a 'borrow' is. How can delivery occur if the lender has also sold his shares? Which purchaser actually owns the 'real' shares. This also highlights the sort of odd distortions that seem to become possible when electronic trading systems replace physical ones.

In the world of share certificates having to be delivered to settle a trade surely this situation (two people being entitled to sell the one lot of shares) wouldn't be possible because delivery couldn't be effected to both purchasers?

I know the markets put limits on the percentage of stock that can be shorted and also make sure a lender has been locked in before allowing a short to occur in order to counter the risks in this activity, but overall conceptually it seems to be a bit bogus.

cuttlefish said:

I know the markets put limits on the percentage of stock that can be shorted and also make sure a lender has been locked in before allowing a short to occur in order to counter the risks in this activity, but overall conceptually it seems to be a bit bogus.

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So would you also have Margin loans vanquished in your new ,only one way market, up. That is borrowing something you don't own and entering a position.
And if you are in a bad mood at the moment you should be blaming the leveraged longs for that. And They are more than 1% of the market and responsible for the prices being so high and these nasty corrections.

And then why not all derivatives. in fact why not all borrowing in the whole economy. what function does that create. See sub-prime!!

Trembling hand said:

And then why not all derivatives. in fact why not all borrowing in the whole economy. what function does that create. See sub-prime!!

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lol Trembling hand I'm interpreting that the above post is intended light heartedly, but in case its not I just want to state for the record that I didn't start this thread because I'm in a bad mood or because I have any vendetta against practitioners of short selling. (if its available then make use of it I'm not stopping you). I'm averse to CFD's so use eto's for short positions. I've got access to day short selling but it doesn't match my trading/investing style even though I suspect its been pretty lucrative for some of late.

I am just interested in having a full understanding of the mechanics of the markets, partly because in extreme circumstances mechanical flaws can create distorted effects that might provide potential opportunities (or help to avoid pitfalls).

So would you also have Margin loans vanquished in your new ,only one way market, up. That is borrowing something you don't own and entering a position.
And if you are in a bad mood at the moment you should be blaming the leveraged longs for that. And They are more than 1% of the market and responsible for the prices being so high and these nasty corrections.

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I think this is a pretty valid point about borrowed money driving up markets, though of course a market doesn't need short sellers to fall. (and doesn't need margin lenders to rise). Also as you state, sub prime is the outcome of over zealous lending morphed via complex instruments. (maybe not so complex either).

But do two wrongs make a right? (manufacturing of stock via the shorting process being a bit analogous to manufacturing of capital that occurs via bank lending)

Not meant to be stirring you. But it does provide a pretty important part of a liquid and stable functioning market. Think about it this way.

Stock prices are basically set by good liquid supply and demand. If the supply or demand of anything is illiquid priced distortions occur. Short sellers protect bulls by supplying added liquidity to the market.

Stock prices are basically set by good liquid supply and demand. If the supply or demand of anything is illiquid priced distortions occur. Short sellers protect bulls by supplying added liquidity to the market.

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I think thats well put Trembling hand, I can buy that argument.

In thinking about it, in property markets, off-the-plan sales are sort of an equivalent - creating additional supply somewhat out of thin air. If demand is genuine the supply materialises and becomes real, if it doesn't the off-the-plan projects get pulled. (actually maybe thats a bit more like fading the sell side of the market depth lol).

Quote:- Short sellers protect bulls by supplying added liquidity to the market.

True or False?
1.The added liquidity was originally the bulls!
2.The bull would be better protected if his stock wasn't short sold in the first place.

I think that all depends on the player , there's a buyer and a seller only one can win .

CecilHills said:

Quote:- Short sellers protect bulls by supplying added liquidity to the market.

True or False?
1.The added liquidity was originally the bulls!
2.The bull would be better protected if his stock wasn't short sold in the first place.

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The riskiest time to short a stock is at the height of the bull, but its also the time that it serves its function properly. Asset prices reflecting value is in the best interests of any functioning market so shorting does serve a function of sorts. Though as well as tempering the bull they also exacerbate the bear and create the short covering volatilty on the way down.

I think Trembling Hand's argument makes sense but would be interested in counterpoint because it could also be argued that the short squeeze enhances volatility in the late stages of the bull. The supply is still artificial and needs to be covered.

CecilHills said:

2.The bull would be better protected if his stock wasn't short sold in the first place.

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Protected. From what. His own ramping of prices then panicking and running for the door while everyone else is loosing their minds?

I do not see what the so called Bulls are worried about with shorts. If you have anyone to be annoyed with its your own camp. It was not the shorts that caused this or any meltdown, its the long and leveraged.

If anything the Shorts help in a crash as that's when they buy, creating a market that the Bulls are either to scared to do or unable because they have no more cash left from buying high.

trembling Hand said:

Protected. From what. His own ramping of prices then panicking and running for the door while everyone else is loosing their minds?

I do not see what the so called Bulls are worried about with shorts. If you have anyone to be annoyed with its your own camp. It was not the shorts that caused this or any meltdown, its the long and leveraged.

If anything the Shorts help in a crash as that's when they buy, creating a market that the Bulls are either to scared to do or unable because they have no more cash left from buying high.

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So now there are two people selling the same stock high in the hope to buy it low again. So it does sound like it is skewing the market into the selling side. But it does bring more liquidity.

Is there any time frame on these transactions? Could I short and then just hang on to this "liability"?

BeterValue said:

So now there are two people selling the same stock high in the hope to buy it low again.

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The two selling the same stock high are selling to buyer or buyers. This buyer, or buyers, is/are hoping (wash your mouth out) it goes up further. At any time the number of share bought = number of shares sold.

The same argument can be applied to stock speculation. What function does it provide?

Liquidity.

Short selling is a value-add to speculation and in turn creates more liquidity.

Quote: Protected. From what. His own ramping of prices then panicking and running for the door while everyone else is loosing their minds?

No, He is protected from his stock being artificially devalued by someone selling who never influenced the price upwards by first buying.

I have no problem with people shorting only those in denial about its effect.