Short selling improves stock markets with liquidity, price discovery and activity that can also improve some shareholder values. Short seller pressure has made managements more accountable as well as sensitive to public, employee and shareholder issues. That pressure has made the management of some companies more open to contrarian views or analytics.
What you learn:
The lesson explains how short selling improves market liquidity, price discovery and market activity. As well you learn how markets improve as shorting pressure improves companies. You also learn how understanding this sophisticated strategy can improve your investing results.
FAQs investors asked about how short selling improves markets
These questions and answers about how short selling improves markets, have overlapping answers which help investors understand how stock markets, investing, and money-making interrelates.
How does short selling improve markets?
Short-selling helps ensure capital markets are efficient, healthy, and functional. It increases market participation and generates valuable data while improving price efficiency, volume, and liquidity, including during market downturns.
When applied to individual stocks, short-selling helps to highlight governance or operational issues and identify overvalued equities. That attracts media and analyst attention, which increases awareness and information sharing among investors, leading to higher trading volumes.
Short sellers are essential in exposing fraudulent activities, weak operations, and underperforming companies. That helps market forces to eliminate poor performers, reduce market risk, and move capital to stronger performers.
Does short selling hurt markets?
No, short selling improves stock markets. Short selling adds liquidity, enhances price discovery, and increases activity. And it can improve some shareholder values.
Short selling can expose a company's capital weakness, poor management, or fraud activity. Also, short selling pressure makes the management of companies more accountable and sensitive to the public, employees, and shareholders. That can also make management more receptive to the views or analyses of others.
The market removes the weak when short sellers attract market pressures to poorly performing vulnerable companies. Markets strengthen by freeing capital from that weak player into stronger, more productive hands.
Do markets ban short selling?
Although exceptions exist, stock markets generally do not ban short-selling except in an extreme financial crisis.
Markets accept that short selling can expose companies with overvalued shares, a weak capital structure, poor management, or fraud. That benefits stock markets by adding liquidity and improves price discovery to increase shareholder value.
Short selling can pressure management to respond to identified and contrarian issues. That can make them more accountable and sensitive to public, employee, and shareholder views.
Markets benefit from exposing underperformers and allowing market forces to remove weak players. That reallocates capital to stronger participants.
Who wants to ban short selling?
Margin traders often blame short sellers for their losses and call for short-selling bans. Their concern is losing money, not market integrity.
However, records indicate that short selling contributes to market integrity by revealing fraudulent activities, bad operators, and companies in weak financial condition. Despite short selling being unpopular with the attacked companies' management and shareholders, markets benefit.
During a market crisis, bans on short selling help stabilize markets. However, inappropriate bans can increase volatility and lower market quality. Regulators are aware of the potential for market manipulation swings both ways.
Does short selling manipulate markets?
Illegal short selling manipulations include naked shorts or short-and-distort schemes. Naked shorts sell more than they own or borrow, and short-and-distort is the opposite of pump-and-dump. Both use disinformation to make money by driving prices lower.
In contrast, legal shorts expose overpriced frauds and financially frail, poorly managed, or obsolete businesses. They can attract market forces for more selling, additional liquidity, and enhanced price discovery to reveal fundamental shareholder value.
Share price pressure makes management accountable to employees, shareholders, and the public and open to contrarian views. At the same time, market forces remove weak companies to redistribute their capital to productive hands and improve markets.
What is the upside to short selling?
Short selling increases price efficiency while exposing flaws in price discovery, hedging opportunities, and pending bubbles while adding liquidity and supporting good corporate governance.
Knowledgeable investors accept that short selling benefits markets with liquidity, and price discovery, as it identifies overvalued shares, flawed companies, and fundamentally weak players. Each improves markets.
Short selling is a helpful financial specialty requiring specific knowledge and sound risk management, like options, futures, or margin trading. None are inherent market risks.
Despite the critical role short selling plays in stock markets, uninformed investors, politicians, and others lacking understanding can support bans. But fact reviews always get bans lifted.
How short selling improves markets
Short selling activity improves stock markets in ways that benefit all investors. Understanding the forces involved increases your knowledge 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 of the company under attack.
This can happen once long investors get worried that the short seller could be right by knowing 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 the selling volume accelerates the downward price, this can quickly cascade into panic selling.
Any significant increase in selling volume can tip the price scale. Once more investors wish to sell than to buy, share prices can dramatically plunge. Still, this short selling activity brings positives to stock markets.
Shorting activity that improves markets:
Liquidity Increased
Price Discovery Improved
Increases Market Activity
Short selling adds liquidity
Any new buying or selling that comes into a market adds liquidity. Short selling does that by adding more volume above the normal levels. Like any increase in volume, short selling activity adds liquidity. That volume would not be there without the short sellers.
Shorts improve 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 each transaction.
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.
Selling pressure pushes markets
Short sellers enter this mix by initially adding selling pressure. Their selling brings 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 gets absorbed by an equal amount of new buying, prices remain stable.
However, should little or no more buying occur, the stock price falls. It will decline to the price that attracts enough buying to balance the selling pressure. In that way, short selling activity helps “discover” the new and correct lower price.
Be mindful, that, at sometime in the future, a short seller has to cover or buy back the same amount that they have sold. At that time, their activity will be on the other side adding buying pressure. And at that point their buying pressure can push prices up.
At some future time, short sellers have no choice but to become buyers. They must produce shares covering their loan to close their position.
Shorts increase market activity
Markets and investors in stock markets usually welcome any increase in market activity. The more the merrier typifies attitudes. As volume and broad based trading activity increases, all aspects of stock market activity function best. Indifferent or agnostic markets view all activity as positive. From the market point of view, more is better.
However, in illiquid or inactive markets or stocks, stirring up activity can produce dramatic price movements. In particular, short activity can bring dramatic price movements in 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 compared to more liquid and active markets. But 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. The downside of that risky move is, instead of waking up a sleeping stock, the short sellers money gets put to sleep!
Contrarian short seller views get broadcast
Most successful major short sellers are a boisterous bunch that release and share their research and opinions freely. Of course, that is after they have quietly taken their short positions. As people with a different opinion, angle or point of view on a stock or markets, they are frequent media darlings that get lots of help to spread their point of view.
That great marketing and messaging activity often stirs market interest and moves prices. This aspect of short selling gets further discussion in a later lesson.
Question Answered!
The lesson answered the question, does short selling hurt markets? It explains how short selling improves market liquidity, price discovery and market activity. We also understand short pressure that improves company performance also makes markets better. The lesson also teaches that understanding short selling can improve investing results.
Lesson takeaways,
Short selling improves markets:
Short selling improves stock markets with liquidity, price discovery and activity that can also improve some shareholder values. Short seller pressure has made managements more accountable as well as sensitive to public, employee and shareholder issues. That pressure has made management of some companies more receptive to contrarian views or analytics.
- Short selling increases stock market liquidity.
- Price discovery is improved by short selling pressure.
- Short selling increases market activity.
- Marketing and messaging activity of short sellers stirs market interest.
Other lessons related to:
Short selling improves markets
Irrational behavior in normal markets
Stock market promoter billions
Canadian investment market base
Costs drive stock position size
Alternate market trading choices
Distracted investing misses profits
Comments and questions welcome
Email me at [email protected].
Subscribe free and get White Top Investor lessons in your inbox!
Make money work for you by knowing how investors think, feel and act. Learn here The Investor Mind.
White Top Investor lessons, website layout, and organization: click here.
Make money work for you
Become a knowledgeable, comfortable, and confident investor using White Top Investor lessons. Learn investing one small step at a time at your own pace to become the master of your financial security and independence. White Top Investor never sells or shares our email list. Learn more.
Lesson links to:
Short story shorting stocks:
Short selling stock explained Lesson 1
Short selling improves markets Lesson 2
Short selling improves companies Lesson 3
9 Short seller facts align Lesson 4
Making money selling short Lesson 5
Shorting stocks has risks Lesson 6
Who’s selling your stock? Lesson 7
Short seller skill sophistication knowledge Lesson 8
Short seller cost control Lesson 9
Short selling has rules Lesson 10
Next lesson 3: Short selling improves companies
Let’s connect, follow me; Twitter LinkedIn Facebook
Share: Short selling improves markets
Buttons below let you share this lesson with family and friends!
Images courtesy FreeDigitalPhotos.net
Lesson code: 505.02.
Copyright © 2011-24 Bryan Kelly
WhiteTopInvestor.com
