Why we need short selling

When China\’s growth will decelerate or come to an abrupt stop is probably the most critical question facing the world economy. But predictions of a hard landing on everything from bad loans to investment-led overheating or inflation has yet to derail the country\’s expansion.

This is because the government-controlled economy is insulated from speculators testing the true voracity of the market, claims Mr Zuckerman. \”We need short sellers,\” he said.

\”The problem with the housing bubble was that for a long time people couldn\’t bet against it. Credit default swaps gave hedge funds specific tools to short the entire market. That pricked the housing bubble.

Yup, far from being those evil bastards of the popular imagination, short sellers are exactly and precisely the people who are able to burst bubbles. Far from banning them, we need to develop the tools to allow them, to make it easier for them, to operate.

For an example of someone shorting a Chinese share (no, not the whole economy) how about this? Our Man thought there was something dodgy about the company. He shorted the stock. Then continued to investigate, as he has done with several similar companies, and was able to find out that it really was all a scam.

It was this same short seller who uncovered the fraud at Astarra Strategic.

Good to have people like him in the markets really, isn\’t it?

So could all the idiots who demonise short sellers please shut the fuck up?

7 thoughts on “Why we need short selling”

  1. Markets are about information, and short sellers are useful extra pieces of information. They also have a lot more balls than long only players. More power to their trades.

  2. I agree, Tim (and Serf); in the final analysis, the next thing a short seller does is buy the stock or bond back, so it’s a wash. But what they do is vital – somewhere between stress testing and a leakdown survey on an engine. Having been trained as a leveraged trader, I also learned early that markets ‘correct’ a hell 0f a lot faster than they trend.

    And, once everyone has the same position (convergence trades are typical, cf the 1998 crisis) then there is only one direction.

    “You really like this market? Then have some more…”

    I’d only choose a stock, bond or index if it was possible to hedge it efficiently.

  3. So if short sellers can really push prices down, how come we are told that long buyers (e.g. commodity speculators) can’t really push prices up?

    Aren’t the shorties just arbitraging price through time the way speculators supposedly do? And hence with no net effect on price over the long term? Which would suggest to me that short-selling can simply push something off a cliff it was going to fall off anyway – changing the timing of something happening. Or is there a difference between the effect on price of these two activities because real supply of shares is (mostly) fixed whereas real supply of commodites is not?

    Tim adds: You’re missing an important distinction. Pjhysical purchases can very much push commodity prices up. It’s futures and derivatives which don’t.

    Short sellers of stocks are equivalent to physical commodity speculators, not to futures such.

  4. Another way of putting it, why does it take a short seller to uncover a scam or an overpriced asset and then make money by shorting it to people who don’t yet know it’s a scam or overpriced asset. That’s just a creative way of profiting from asymmetric information, not getting the information out there.

    The uncovering of scams and overpriced assets is surely the duty of a rational investor, who then achieves a similar effect on the asset price to the short seller by not buying it. The fault in the market is that many of our investors are not rational – pension funds, investment vehicles and other beasts who don’t get too bothered to look into the details of something before buying it. Perhaps these funds should start headhunting successful hedge fund managers.

  5. They do; but it’s not necessarily always a comfortable cultural fit. Years ago I worked for a publicly quoted Cocoa trading company and learned that a particular Merchant Bank from time to time bought and held our stock. So I had them round for lunch…

    Surprised I was when they told me that they owned our stock as a proxy for owning Cocoa. Quite possibly I interrupted: “But there is no correlation whatever between the price of cocoa and the performance of our trading operations. Because we hedge about a third of our inventory forward (selling futures) and, in truth, we run the same risk as a speculator in chasing high prices, which is why our hedging programme, while it works over time, may not work in a given quarter, or even a given year. While we speculate a bit, if it works, it’s bunce, rather than high quality revenue…”

    This gave them pause for thought. The conclusion was, if you like Cocoa, buy Cocoa, preferably physical, spot or forward. As has been pointed out, you don’t add much price pressure by having a punt in the futures market, as the basis traders will soon iron out obvious anomalies. But selling stuff you don’t own in a market dominated by physical trade is open to a huge swathe of risks, but is necessary in a market which thrives on arbitrage. And a market which does not is inherently more potentially risky than one which does…

  6. Thanks for the clarification, Tim.

    I was going to argue that this falls between physical and futures speculation but you’re right. However, I imagine naked short selling would be regarded as a pure derivative, essentially zero-sum bet. In which case one wonders why all the shouting about it a few years ago.

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