Whenever the market plungesor individual stocksstumble, fingers point toshort sellers.
Shortselling is thepractice of betting against stocks in the hopes of profiting if their share prices decline. It's the reverse of what most of us do — buying stocks or mutual funds "long," with the expectation that prices will rise.Tradersthat engage in short sellingwant to see their targeted stocks stumble.
"When you short a stock, you're really rooting against the company," said Chuck Wolff,a Scottsdale, Ariz., investor, who called one day recently when the market was tanking. "If somebody dropped a bomb on acompany, you'd go out and celebrate."
Wolff, whodescribes himself as a "retired guy with a small portfolio," doesn't short stocks andwonders why financialregulators allow the practice to continue. Of all the legal tactics utilized by hedge funds and other market participants, short selling has one of the worst reputations.
Thenegative perception partly reflects the reality that most mainstream investors don't engage in short selling— and shouldn't— as it's potentially quite risky. With regular or "long"investing, you buy shares withthe expectation that the price will rise. You receive any dividends that the company pays, and you don't need to worry about paying interestcharges tohold the stock.
With short selling, you similarly want to buy low and sell high, but the chronology is reversed. You start bysellingshares you don't own — and don'twant to own becauseyou think the stock is overvalued. Youborrow the shares from someone else, typically a brokerage, so thatyou can sell them now, with the hopeof buying later at a lower price, thereby closing out the position. The proceeds from thesale getdeposited into a "margin" account, a type ofholding pen for your collateral.
If the shares rise,thebrokerage will ask youto put up more collateral in what's known as a margin call. Investors who buy stocks long can lose no more than their original investment. But short sellers face unlimited losses,if the price keeps movinghigher. For example, a $10,000 short position in Weight Watchers InternationalonOct. 16 would have morphed into a $26,900loss four days later, according to Niall O'Malley,portfolio manager at Blue Point Investment Management in Baltimore.The reason: Oprah Winfrey announced she would buy10%of the company, quickly pushing up the price.
So much for the reason you probably don't want to try this at home. Doesshort selling offer any benefits to the market or society?
Short sellers say they make the market more efficient and liquid, which helps to reduce bid-asked spreads and other trading costs for everyone. They also claim to provide important information— a sobering, contrarian view on a company's prospects— that can lead to more realistic prices and keep valuations in check. Short sellers also say theyhelp to expose poorly run corporationsand ferret out inflated accounting numbersandsigns offraud.Enronis an example commonly cited.
Short sellers can do damage byspreading negative newsif not falserumorsabout companies —just like long buyers can. In 2008, the SEC curtailed short-selling inthe shares of largefinancial corporations at a time when the solvency of severalsuch entities was under question and the public was losingconfidence in the system.
Yeta study of that and a fewother recent examples of short-selling restrictions, by the Federal Reserve Bank of New York,concluded that curbs on short selling "seem to have the unwanted effects of raising trading costs, lowering market liquidity and preventing short sellers from rooting out cases of fraud and earnings manipulation," according to the researchers. "Thus, while shortsellers may bear bad news about companies' prospects, they do not appear to be driving price declines."
Short sellers won'twin many popularity contests, but it's hard not to see some benefit in whatthey do. The trading tactichas managed to endure through many prior stock-market downdraftswhen sellers became scapegoats. Suchgrudging acceptance islikely to continue.
Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.
