FOOL'S EYE VIEW
Shorters Are Greedy Speculators

By James Carlisle
July 26, 2002

The 'short-selling' of shares has been a hot topic recently, with many people blaming it for much of the recent the stock market turmoil. But it's not at fault and, even if it was, what would be wrong with that? Selling is as much a part of the free market as buying and the Financial Services Authority is right to resist calls for its regulation.

What is short-selling?

"Shorting" is selling shares that you don't own. Let's say that I sold you 100 shares in Vodafone and agreed to give them to you in five days' time. If I don't own the Vodafone shares already, then I'd need to buy them at some point in the next five days, so that I can fulfil my side of the bargain to you. Until I buy them, I'll be 'short' of 100 Vodafone. What I'd be hoping is that the Vodafone share price goes down, so that I can buy the shares I need for less than I sold them to you for.

The important thing to note is that the selling and buying is no different from any other buying and selling. It's just that with 'shorting', you do it the other way around from usual: sell first and buy later instead of buying them first and selling them later. In the interim you have a shortage of the shares (and therefore want the price to go down) instead of having a net positive (or 'long') position (and therefore wanting them to go up).

The normal way for institutions to go about shorting is to borrow the shares first from some contented long-term holder and then sell them in the market. In this way, the shares are owed to the 'contented long-term holder' and, when the time comes (according to the borrowing agreement), the 'shorter' will have to buy them back in the market in order to return them.

When private investors talk about 'shorting' they generally just mean that they've made a straightforward bet on the share price going down. It can have the same effect in the market, though, because if the bookie has more people betting on the shares going down than betting on them going up, then he might decide (assuming he doesn't want to gamble himself) to short the shares to 'cover' his position.

Before going any further I should stress that 'shorting' is a very dangerous game to play. To start with, the market prices shares so that they ought to give better returns than cash over the long term (although the market will get it wrong from time to time). Therefore, on average over the long term, you'd expect shorting to lose money. Also, since there's theoretically no limit on how much a share price can rise, shorting exposes investors to unlimited losses. It is definitely not something to be trifled with.

What's the fuss about?

Most people are net holders of shares and they benefit from share prices rising and suffer from share prices falling. The shorters, on the other hand, are in the exact opposite position. It's no surprise, then, that the two camps don't exactly see eye to eye. Anyway, people like to have someone to blame and, with the stock market falling recently, 'shorters' have been an obvious target. But they really have very little to do with it and that's what Howard Davies was saying yesterday.

The FSA has been looking into how much 'shorting' goes on by looking at the figures for how many shares are being borrowed (it considers this to be a good indicator). The conclusion is that, at any point in time, around 2% of the stock market is being shorted. That's hardly a massive amount. What's more, that 2% figure has apparently not increased significantly while the market has fallen. The FSA boss also pointed out that countries which regulated short-selling in some way had also seen severe stock market falls recently. However, the FSA is quite rightly looking at increasing the amount of disclosure that short sellers have to make. At the moment it is neglible compared with the disclosure required of those that hold shares.

The antithesis of long-term investment -- but so what?!

The real reason that a lot of people don't like 'shorting' is that it's the antithesis of long-term investment. By taking shares in exchange for cash, long-term investors can legitimately claim that they are providing businesses with capital to grow and expand and create jobs and all that sort of stuff (or they've at least taken the position of someone else that provided that capital in the first place).

By taking the exact opposite position, extracting cash and establishing a shortage of shares, the 'shorters' are effectively removing capital from business and thereby restricting their growth. For this reason, some people appear to see shorters as some sort of threat to our capitalist society, but that misses the point entirely. Some enterprises should have their capital removed and their growth restricted, because the capital is better employed elsewhere.

The market, by balancing buyers and sellers is capitalism's way of making sure the capital goes to the right places. So the market needs people that are prepared to make buy and sell decisions and it really makes no odds how much of a share someone already owns (or is short by) when they decide to buy or sell it. It may be a little tawdry, but the whole of capitalist economics is based on selfishness and greed. Shorters may be greedy speculators, but a bit of greed and speculation is what makes the capitalist world go around!