The recent economic turmoil has sent people scrambling for someone to blame. One popular target is short sellers, those stock traders who sell borrowed shares and profit when the prices decrease. Recently, there have been proposals to put limits on when people are allowed to short stocks, including reinstating the uptick rule. Short sellers are taking exception to all the blame being directed toward them, pointing out that they are simply profiting from the downturn, not causing it.
With all of this discussion going on, you probably have numerous questions. Why are short sellers so reviled? Would the uptick rule really stop them? And what is short selling, anyway? Let’s use a simple example:
I’m an investor, and I feel that the Zipper, Yak, and Xylophone, Inc. (ZYX) company is going to decrease in price, due to a recent increase in yak feed prices. If I want to profit from this price move, I could sell any shares of ZYX that I own and then repurchase them at a lower price, which would allow me to pocket the difference. If I don’t own any shares, though, I have to look at alternate ways to make a profit.
Here’s where you enter. You have an account at the same brokerage that I do, and you own one hundred shares of ZYX. If I want to short sell ZYX, I can have the brokerage sell your shares, leave you with a virtual IOU, and give me the money; then, after the shares drop in price, I buy the stocks back, returning them to your account without you even noticing (the brokerage would not inform you that your shares were being used to short the stock).
If the share price is $50 when I short your stocks, I’ll receive $5000 for selling them. When the price per share goes down to $30, I can buy them back for $3,000, making $2000 by shorting your shares of ZYX. (In actuality, I won’t make that much; commission fees in buying and selling the stockes, margin fees on the money borrowed from the brokerage when shorting the stocks, and the cost of any dividends paid out while I’m shorting your stocks will lower my profits. To make the math simplier, I’ve omitted such costs from all the math here, since the costs would vary with the brokerage and time the short was executed.)
Not all short selling results in profit, though. If I’m wrong about ZYX and it goes up in value, I’ll spend more money to replace the borrowed shares than I got by selling them. Should ZYX go up to $60 per share, I will spend $6000 to replace them, a loss of $1000 (on top of the aforementioned expenses). Furthermore, the downside risk of shorting stocks is greater than owning them. If ZYX goes bankrupt while you own your 100 shares, you will have lost $5000. However, if the ZYX share price shoots up to $110 while I’m shorting them, I’ll have to spend $11,000 to buy them back, a loss of $6000, more than the total cost of the stocks initially. The losses from shorting can theoretically be unlimited, as long the per share price keeps rising (although, that’s somewhat unrealistic).
Now that we have a better idea of what short selling is, you can probably see why it rankles so many investors. If I’m making money when your investments are declining, chances are you aren’t going to be too happy with me. I’m not really causing you to lose money if your stocks go from $50 a share to $30 a share, since I’m just a fellow investor and can’t influence stock prices, but if I’m cheering for your stocks to fall, it’s hard to avoid thinking of me as the enemy.
But would the uptick rule actually stop short selling? The uptick rule says that, if I’m going to short a stock, I have to wait until there’s an uptick, that is, for the selling price of the stock to be higher than the last previous sale. This rule had been in place until 2007, when it was repealed, but in light of the past year’s turmoil, there’s plenty of talk about bringing it back. The goal is prevent short sellers from piling on when news gets bad, continually driving down the price and beating down the stocks.
My view: while a reestablished uptick rule may decrease short selling of beleaguered stocks, it won’t necessarily save them. Stocks will still be able to fall, as the the owners sell their stocks and mutual funds need to gain cash for redemptions. All that banning short sales may do is prevent those few people who are benefiting from the falling prices from, well, benefiting.
Furthermore, with the number of trades that are executed each day, especially for large cap stocks, the uptick rule may be little more than a formality. Most popular stocks will be traded hundreds, if not thousands of times each day. A dedicated short seller would simply need to wait for an opportune moment and leap in after a small uptick, and then be able to short sell to their heart’s content.
I personally am interested in just what the Securities and Exchange Commission will decide regarding this practice. Hopefully, you now have a better understanding of short selling, and might just be more interested yourself.
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