Saturday, October 13, 2012

Almost everyone is (or has been) a short-seller

People often have difficulties wrapping their head around the idea of selling a stock short. It seems odd. Once people understand how it works, they also tend to perceive short-selling as immoral. They also assume that only a few malcontents engage in that sort of transaction.

But everyone either has been, is, or will be a short-seller.

When you short a stock, you're basically borrowing a stock and immediately selling it in the market. When the lender of the stock demands the stock back, as the short seller you've got to buy the stock back in the open market and deliver it to the lender.

Now consider someone who borrows from the bank. You borrow a deposit and immediately sell it in the market. When the bank demands the deposit back, as the borrower you have to buy the deposit back in the open market and deliver it to the bank.

These two transactions are the same transaction. Borrow an asset, sell it, and when the lender requires delivery, buy it back and deliver it to the lender. Anyone who borrows from a bank is a short-seller.

Part of the ethical argument against short selling has been that short sellers are hoping for lower stock prices. The reason short sellers want a stock's price to fall is that it allows them to buy the stock back at a cheaper price and deliver it to the lender of the stock, thereby earning a good profit. Wishing for a lower stock price is presumably the unethical part. It's a form of schadenfreude.

But anyone who borrows from a bank wishes for the very much the same thing! When the bank calls in your loan, you really hope that those deposits have fallen in value. That way you earn a profit. You earn a profit because you don't have to sell as many real resources to repurchase the deposits as you initially bought with the first sale of deposits. There's also schadenfreude involved here. Wouldn't you prefer if the bank had gone belly-up? Or that your nation's central bank had gone hyper-inflationary? Either way, buying back the deposits will be a cinch.

So if short selling is only done by vultures, so is borrowing. If the former should be banned, so should the latter.


  1. I think the issue is more about naked short selling.
    Where they borrow stocks that don't exist. I.e the broker /or banker lends more stocks or money than what really exists and can be legally lent.

  2. Hey stockmaniac, you're right that naked short selling is controversial. My post was mainly to point out the similarities of borrowing to regular shorting.

    That being said, the average person can engage in something akin to a naked short. Say you pay for a couch with a cheque but your chequing account has no funds. You've basically sold a deposit although that deposit never really existed. As in a naked short transaction, the trades stays unsettled until you either return the couch or borrow from the bank so you can write a new cheque. But paying with bad checks is certainly questionable practice - you will ultimately get disciplined. Perhaps it should be the same with naked shorting?

  3. But in this example of yours, the over all market price for a couch is not altered if a person "pays" for it using a bounced check. He is still held responsible for either paying for it or returning the couch and maybe also pay damages.
    Naked short sellers distort the market price of stocks by artificially creating excess liquidity. They also get way with making huge profits when the stock falls in value and is some cases if the stocks moves against them, they can still get away for free as there is no one calling for those stocks they "borrowed", as it never really existed in the first place.

  4. To add to this. Hope you have heard of Deep Capture?
    Worth some weekend hours on it.

    thanks for posting my comments.

  5. Thanks for the link. Interesting metaphor... it seems like we've both used the market for money as inspiration for explaining short selling.