Felix Salmon on Short Sellers

What happens when companies engage in fraudulent activity? Short-sellers get wind of it, and, by selling the stock of the company in question, depress the share price and save uninformed investors some of the loss they would otherwise have suffered had they bought in at an undepressed level. How much is that worth? According to Xiaoxia Lou and Jonathan Karpoff, somewhere between 0.2% and 1.5% of the firm’s market cap.

But what if the short sellers have it wrong, and the company in question is not engaged in fraud? Well, in that case the uninformed investors have just been given the opportunity to buy into that question at a discount, thanks to the shorts. They win again!

Is there any downside to short-selling? Not really: the authors say that “there is no evidence that short selling exacerbates a downward price spiral when the misconduct is publicly revealed”.

So thank you, short-sellers, for saving us from buying in to fraudulent firms at inflated prices, and from giving us a nice discount on the share price of non-fraudulent firms. You rock!

That's Felix Salmon.  We need to make short selling easier not harder.  Wouldn't it be great if someone like Jim Cramer routinely recommend shorting a stock?


Since no one cares about normal short selling, you must be implicitly defending naked short selling.

Naked shorts should bother even the guys on this site. A naked short is not “selling the stock in a company†. Selling the stock in the company is “selling the stock in the company†. A naked short is pretending to be “selling the stock in the company† and would be fraud anywhere but Wall Street. A naked short artificially and deceptively appears to inflate the supply of the stock in a company and is sure to deflate the value of the shares unless once again the law of supply and demand is found to be a myth.

wait a second...when acompany is not engaged in fraud but is attacked by short sellers, then investors win because they can buy cheaply. what about the investors who need to sell? are they benefited by a depressed share price?

Alex, it would not be good if Cramer recommended shorting, because shorting involves unlimited downside risk. Some one wrong as often as Cramer is could get a lot of people hurt.

SJ47, People did care about regular short selling, like when they banned short selling of some financial stocks last year and tried to blame shorts for killing the good banks who obviously had very good reasons not to disclose the quality of their assets. Naked shorting is a paper tiger; failure to deliver is extremely rare. If I wanted to buy a company cheap I'd be glad if there were lots of naked shorts. But if the shorts are right about the company's future they're doing us all a favor.

Yeah, but there are many more scenarios that seem to be forgotten... A short seller can artificially drives down the price of a stock(lets say Apple) by pushing negative PR on a product(iphone), buys the stock at a reduced rate, then sells it after every sees how good the product actually is. (ask Jim Cramer about that) The argument that it is good for regular investors either way is an argument that they are not needed. If a short seller drives down the stock when it should not have and lets people get it cheaper, how does that help the regular investor that needs to cash in now? But even with this downside short selling is an overall positive way to achieve high market quality.

But what if the short sellers have it wrong, and the company in question is not engaged in fraud? Well, in that case the uninformed investors have just been given the opportunity to buy into that question at a discount, thanks to the shorts. They win again!

Call me naive, but ideally shouldn't the stock price of a company that is performing well (or all else equal, non-fraudulently) be higher than the stock price of a company that is not performing well? If keeping the stock price low for investors is an unmitigated good, then why don't we legislate all Fridays as "Everybody's a Penny Stock Day!"?

I'm on the fence about greater short-selling regulations, but this struck me as a remarkably dumb argument.

If you're bullish on the company and think the shorts are wrong, go long at a better price. If you think they're right, don't. Why quibble about a technical delay in locating shares to borrow? It's not fraud. Is factoring receivables fraud? Is a student loan fraud? Is it fraud to ask your uncle for a loan until you find a job?

It seems the defense against naked shorting, if this post was what this is about, could be the government playing defense (how's that working out for ya'?) or it could be sophisticated investors playing offense. If the company isn't taken to bankruptcy by the death spiral of credit rating following stock price, then the shorts have to cover. Perhaps the best financial product to oppose shorts would be to buy the company's bonds and the company can call them in saner times. Warren Buffett was such a sophisticated investor. He got even better terms to compensate for his high-powered money. He has de-commoditized his dollars. Just because something passes the fraud test doesn't mean we have to wait around for the government to get their act together.

Of course short selling is "win-win" for buyers: any selling is, because it lowers prices. On the other hand, short selling is terrible for sellers to the same degree it is good for buyers. Why not include the sellers in our moral universe?

There are good reasons for making short selling easy, but the above reasons aren't particularly persuasive in my view.

Few financial practices have ever been as unfairly vilified as short selling; as far as I know, not since the days when joint stock companies (and even earlier, lending at interest) were new and contentious has a financial instrument been so ignorantly scapegoated. Short-selling is typically engaged in by the most informed and judicious of investors, and can (or at least could) be an efficient way of allowing bubbles to be deflated sooner than they otherwise would be.

As for Cramer, he does recommend short-selling, but he does it in code, so as not to arouse the suspicions of financial regulators or the FCC:
when he says "weak buy" he means "weak buy/hold/sell/I don't know".
when he says "strong buy", "sure thing", "no potential downside" etc, he means "short sell."

We could very definitely benefit from a new law banning all academics from commenting in any way on futures or options markets. It's entirely for their own good. :)

Perhaps we should encourage put options for retail investors just to avoid the whole unlimited liability problem. But yeah, I think short sellers are the unsung heroes in this crisis (they shut down CDOs and subprime origination long before most of the market had accepted just how toxic they were).

Felix, I see you're faithfully playing your part. Problem is you're becoming a bit of a caricature of yourself. Tip: it's ok to abandon pre-2008 thinking when it's 2009. As they say: "nothing fails like success."

I see Tom Powers has made exactly the same remark above.

The argument is incorrect. Stock-trading is basically zero-sum so the short's gains must come from other investor's losses. Note short-selling effectively increases the number of shares outstanding so although each share may lose less when the fraud is revealed there will be more shares. Add in the losses from naive sellers who didn't get as good a price and the other investors lose on balance.

GOOD NEWS!!! There is finally great new movie out about market manipulation, the SEC, and short selling called: "Stock Shock." For those of us that want to understand some of the inner workings of the market, it is a must-see. Very easy to understand and entertaining. Amazon has it or stockshockmovie.com has a trailer.

Thanks for this post. You know, I'd really appreciate a post where you suggested news sources that you consider good ones.

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