The case against allowing short sales

Why the physical short is bad.

The recent Gamestop short squeeze highlighted short selling. As I’ve explained here at slightly greater length, a short sale is basically selling an IOU note denominated in stock. After completing the short sale, the short seller holds some amount of cash and has the obligation to deliver a share of stock to another person at a particular point in time.

This is true both for “naked” short selling (theoretically illegal) and “covered” short selling (entirely legal). The difference with a “covered” short is that there is a small fee involved. This is sometimes known more precisely as a “physical short,” because there are other ways to have a “short” (pessimistic) position on a stock. The problem with this is that while the return from a short sale is private, the risk is socialized.

The way a short seller makes a profit is that if the stock price drops before they’re required to deliver a share, they can meet their obligations by buying stock at a lower price than what they got from selling an IOU.

On the other hand, if the price of the stock increases, the short seller loses money. Theoretically, there is no limit to the amount of money the short seller can lose meeting their obligations.

In practice, if the stock increases enough, the short seller declares bankruptcy, passing unexpected losses on to other parties. Profit is individual; loss is socialized.

Socialization of risk is bad enough, but short sales create their own risks.

In general, financial instruments are priced and balanced around a theoretical expected return of zero (relative to the market). This, in turn, means that cases where the risk is socialized are a little bit more profitable, since theoretically unlimited losses are cut short by limited liability, bankruptcy, and in some cases (c.f. 2008 financial crisis) targeted bailouts designed to prevent an institution from collapsing. A significant share of financial regulations are designed to try to prevent socialized risk events.

This is in general bad, but in the case of short sales, it’s worse, because short selling can create the conditions for its own failure. If enough people decide to short enough shares of the same stock, short selling can create the conditions where short sellers risk default. This is known as a “short squeeze.” If there are enough short sellers out there required to buy stock to fulfill their obligations, and existing shareholders don’t sell quickly enough, the price of a stock can spike enormously as short sellers get into a bidding war.

There are other ways to bet against a stock.

The major argument offered in favor of short selling is that it offers traders who do not own the stock a way to bet against the stock, therefore signalling that they think the stock price will go down. Existing shareholders can usually simply sell their shares or buy put options to hedge against the risk the share price goes down. Puts fill a similar niche as short sales, without the same theoretically unlimited losses.

A trader does not need to own a stock to buy a put. A put is a contract giving someone a right to sell a stock at a specific price in the future. Both sides of the contract have limited risk; the option holder is effectively betting the stock price will drop. If the price goes down, the holder of the option can buy the stock at a low price, and then exercise the option to sell the stock at a high price.

Why are short sales used at all?

The short sale has no redeeming social value, and it’s risky. Short selling can cause enormous losses. Why are they used at all when there are other less-risky ways to bet a stock will go down?

First, profit and liquidity. When pricing is working efficiently, a put option has a smaller upside to go along with its smaller downside. Buying a put option also uses cash, tying it up for a short period, while a short sale generates cash, freeing it up for a short period. Both of these features make short sales more desirable to individual traders, but have no positive effect on the market level.

Second, because shorts can be abused. Short selling is a stronger tool for abusively manipulating the market. It’s easier to make existing shareholders panic using short sales than puts, because short sales are sales. Driving down the price of a stock may be desirable for other reasons, but it’s also exactly what the short seller needs in order to make money on a short sale. From the perspective of society at large, this is a bug, not a feature.

Dr. Tomas McIntee is a mathematician and occasional social scientist with stray degrees in physics and philosophy.

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