White Top View series on Short Selling, Part 9
Well informed investors know that short selling improves stock markets for everybody. Today’s discussion that introduces the positives of short selling continues as Part 9 of the White Top View series Short Story on Short Selling . Read the earlier posts by clicking on the links at the bottom of this post.
7 Ways stock markets improve through short selling
Short selling improves stock markets 7 ways. It is an important part of the overall investing scene. Short selling brings benefits that help create a healthy and efficient stock market. That benefits all investors, short or long, and the economy.
Downward price pressure from large short positions remains the most obvious market force of short selling. Such price pressure can quickly erode share values.
This can happen once long investors get worried that the short seller knows something that they do not. On the chance that the shorts are right, some shareholders may begin selling.
Some sellers tiptoe towards the exit, but others completely and quickly bailout of their entire positions. Once selling volume accelerates the downward price force can quickly cascade into panic selling.
Any significant increase in selling volume can tip the price scale. Once more investors wish to sell than buy, share prices can dramatically plunge. Still this short selling activity brings positives to stock markets.
Short selling improves stock markets 7 ways:
Price Discovery Improved
Increases Market Activity
Forces Management Accountability
Prioritizes Corporate Issues
Expresses Contrarian Views
Produces Unique Analytics
Today we cover the first three market positives of short selling, liquidity, price discovery and increased market activity:
Short selling adds liquidity
Any new buying or selling that comes into a market adds liquidity. By adding more volume above the normal market volumes, short selling activity adds liquidity. All selling volume which comes from short selling activity simply would not be there without the short sellers. That activity adds liquidity that otherwise would not be in the market.
Short selling improves price discovery
Price discovery is the essential pricing mechanism of a normal market. The market seeks a price that willing buyers and willing sellers agree on. Discovering or finding a price that balances buyers, sellers and volume triggers the transactions.
Basic supply and demand forces move prices up and down until buyers and sellers agree on a satisfactory or acceptable price for a given quantity. If one side or the other has more demand or supply, the price shifts to bring balance. That point of balance is the “discovered” price.
Short sellers enter this mix by initially adding selling pressure. They bring more supply. That can begin the process of forcing prices lower.
Should enough new buying emerge in response to the increased supply, little price change happens. As long as the number of shares being sold get absorbed by an equal amount of new buying, prices remain stable.
But should little or no more buying come in, the stock price will fall. It will decline to the price that attracts enough buying to balance the selling pressure. In that way, the short selling activity helps “discover” the new and right lower price.
We remain are mindful that, at sometime in the future, a short seller has to cover. At that time their activity will be on the other side. And that activity will then add buying pressure. At that point, we can expect that prices will rise. At some future time, short sellers have no choice but to become buyers. They must do so as they must buy back shares to cover their loan and close their short position.
Short selling brings more market activity
Markets and investors in stock markets usually welcome any increase in market activity. The more the merrier typifies attitudes. As volume and broadly based trading activity increases, all aspects of stock market activity function best. Markets view all activity as positive. It is a case of more is better.
However, in illiquid or inactive markets or stocks, stirring up activity can have very significant price impacts. Short activity in particular can bring dramatic price moving effects on quiet or sleepy markets.
At times quite slumbering stocks get stirred into action by short selling. However, shorting in a quiet market is very risky. But the short selling may bring market and media attention that stirs activity. A comatose stock can quickly erupt into a buying or selling frenzy in moments. Or, instead of waking up a stock, it can put the money to sleep!
Next, in Part 10, of the White Top View series Short Story on Short Selling we will discuss the other four market positives of short selling.
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To read all parts of the White Top View series, the Short Story on Short Selling, click the links below:
Part 8, Short selling has rules
Part 10, Four more positives of short selling
Part 12, Shorting stocks is hard