Definition

‘Restraining The False Optimism That Always
Leads to Disaster’

Professional investors rely on short selling strategies to accomplish their investment goals. A short sale is any sale of a security the seller does not own or a sale that is completed by delivery of a borrowed security. Through their prime broker, the short seller promises the lender to replace the borrowed shares in the future, and pays certain costs until the borrowed shares are returned. (Short sellers receive a credit rebate on sales proceeds that come into the prime broker’s account.) Shorting is more common in fixed-income and commodity markets than in equities.(4)

Short selling is an integral part of the workings of capital markets, providing liquidity, driving down overpriced securities, and increasing efficiency. “The goal of efficient financial markets is to have prices reflect [the] collective best guess. . . . [O]ver-rated stocks and stock markets, including destructive bubbles, are best fought by allowing all opinions to affect prices.”(6) Without short sellers, as the financier Bernard Baruch put it, “there would be no one to criticize and restrain the false optimism that always leads to disaster.”(7)

Short selling is common in business and peoples’ lives. Farmers, for example, who sell grain futures before their anticipated harvest are conducting a form of short selling to lock in a price.

In equity markets, there are many kinds of short sellers. The vast majority are market neutral, where the seller has no view of a particular company’s outlook but simply is locking in a spread. (9) The spread is the difference in price between what a broker-dealer charges an investor for a security (the “ask”) and what the dealer pays to buy that security (the “bid”). This strategy occurs, for example, with buyers of convertible bonds, who short the underlying equity security as a hedge.(10) An investor may also want to hedge the risk of a long position — expecting prices to rise over time — in the same or a related security. A portfolio that includes both long and short positions of stocks will generally have lower volatility than one which only has long positions.(11) Long-short portfolios also tend to produce slightly higher returns than the average hedge fund over the past decade, according to Hedge Fund Research, Inc.(12)

During the turmoil in financial markets between October 2007 and October 2008, short-bias funds rose 21.4 percent, compared to a 22-percent drop in the Standard and Poor’s 500 Index, demonstrating the importance of short selling in diversifying investment strategies.

Risk arbitrage is another area where traders, in connection with an announced acquisition, may short the acquirer and go long the target, since an acquirer often uses its own shares to make an acquisition, thereby diluting and lowering its share value. An investor may also manage risks in a portfolio based on an index by going long options and/or futures and then shorting the individual equities that make up the corresponding index.(13) In this case, the trader has no fundamental view of the index stocks being shorted; they are simply locking in a spread, the difference between the “bid” and the “ask.”

Market makers may sell short to meet customer demand and maintain orderly markets. They provide liquidity in rapidly moving markets where a failure to meet orders would impede the efficient functioning of the market. Markets’ depth and liquidity depend upon the ability of various market participants to employ shorting techniques.(14)

Short sellers profit, too, by buying shares at a lower price to replace shares they earlier borrowed through a prime broker and sold at a higher price.