Three Short Points

I. Way Too Short

Borrowing a drill from a neighbour with the intent of selling it before buying him another is not a common activity witnessed in leafy suburbs on sunny Saturday afternoons. But during the week large numbers of investors and traders do this with stocks. The idea is to borrow and sell it at a high price and buy and return it when it falls.

By borrowing and selling the drill, I have in a sense created another. My neighbour still owns one. And so does the guy I sold it to. This nets out because I am ‘short’ one drill. The addition doesn’t really help matters if pictures need to be hung in more than one house at the same time. But if all that matters is beneficial ownership (as it does in the case of financial assets) then we can create more than actually exist. If the buyer of the shorted share lends it out again, there is a further increase in the assets (and liabilities) that exist.

Theoretically, shares can be lent and sold ad infinitum. Should we get worried about a ballooning in risk and exposures?

In practice, only a small fraction of shares are actually lent, since owners are only free to sell what they have not lent and they need to be hooked up to the right infrastructure to lend shares (they get a fee, of course). So, it is quite harmless most of the time. Usefully, the fraction that is lent out tells you something about how pessimistic those who can go short are on the stock’s future path.

The risk arises when that fraction is relatively high because it can influence the future volatility of the stock. So-called short squeezes occur when a lot of borrowed shares need to be returned in a small window of time (this is probably the most famous example of recent times).

II. Short on Return

Shorting is an activity with a negative expected return, in general. On average you should expect to lose money by engaging in it. This activity is another example of how being exposed to volatility is not a sufficient condition to expect to generate a return (like lemon cake).

Shorting is either undertaken by (1) people with sufficiently in-depth knowledge of why a stock should trade at a lower price or by (2) those looking to offset some related risk to which they are exposed. In the first case, the expected return to this strategy can be positive, but only if the initial return implied by the price is wrong and needs adjusting. In the second, using shorts as hedges usually reduces risk and expected return, but careful use means it can offset more of the former than the latter.

III. No Shorts Allowed

In most instances shorting provides a useful service. It keeps the cost of equity from running too far away from where it should be. Some liken it to policing the markets, since several prominent frauds have been unearthed this way.

However, shorting draws a lot of negative publicity as governments blame it for share prices of banks tumbling in times of stress and company executives don’t like the idea that a swashbuckling hedge fund manager can impact their net worth. Most bans imposed by governments in recent years expose ignorance and fear ahead of anything else. To what extent should a ban serve a useful purpose beyond appeasing popular outcries?

A ban on shorting doesn’t stop owners selling. If sellers are happy to sell at $50 and above and buyers are happy to buy at $50 and below, then the market price will settle at $50. Only if the spectating short sellers were willing to sell at less than $50, would the clearing price be lower. The ban assumes that the natural sellers and buyers are pre-disposed to a more lofty outcome. This does not have to be the case.

However, around the times these bans are utilised, the uncertainty can be high enough that the ban buys some time for buyers and sellers to decide on a more sensible price. Distressed prices can reflect anything but a rational assessment of fundamentals and letting dust settle can help with the orderly functioning of markets. Short bans should be carefully employed and only for as ‘short’ a period of time as possible.

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6 thoughts on “Three Short Points

  1. On (I): To the extent that owning a share on a day constitutes the rights to collect dividends and to vote, is beneficial ownership really that different for stocks and for drills? Only one party votes the shares and only one party collects the dividends, so what’s doubling up? What is the difference between selling something with the agreement to buy it back at a certain price (effectively renting it out at a pre-specified rate) and a short sale?

    On (II): Keep in mind that a short position in an insurance asset (namely one with “negative beta” meant in the vaguest sense) should have a positive expected return.

    Also, do you know the relative volumes of open short positions assumed by hedging derivatives and speculation? What else are shorts good for?

    Reply
    • The original owner maintains an identical economic interest in the equity, i.e. is exposed to all cash flows and price movements. The borrower has to compensate for any dividends that the owner misses out on. And, the owner continues to count the equity as an asset. Thus there are now two people with identical economic exposure to the stock. But, you correctly point out that only one of those can vote – to my mind this is a minor point as, except in extreme circumstances, shareholders tend to be passive on this.

      Reply
  2. On point II, most assets are not insurance assets so this is an exceptional case. I think you make a very valid observation (this is essentially how insurance companies make money). But thinking about insurance as purely an investment strategy is missing the non-investment related benefits than accrue to the person who is long the insurance, i.e. there are hidden benefits. Worth exploring in more detail, I think, so thanks for the feedback, JRD.

    Reply
    • Should think not. Heard rumours once than an obscure and esoteric branch of economics used a very similar term, but can’t imagine it’s widely talked about. Could call the project “Investigating Short-selling Linkages and Multipliers”, or ISLM for short. That has a nice ring to it.

      Reply
  3. Pingback: Wheeling and Dealing | Expecting Returns

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