Thoughts on Short-Selling By Arnold Kling

What is short-selling? How can short-selling destroy a good company?1. Short-selling explained

The easiest form of short-selling to understand is “naked” short-selling. I think that XYZ stock is going down, and so I tell my broker to sell 100 shares for me. Eventually, I will have to buy 100 shares and either realize a gain or a loss.

If the stock goes down, then it’s up to me when I buy those shares. I have a profit on paper, and I take the profit when I buy the shares. I sold at $20 (say) and bought at $10 (say), so I make $1000.

If the stock goes up, my broker starts pestering me with margin calls. She asks me to put cash or short-term Treasury bills in my account. That is because she is afraid I will walk away and leave her to have to buy the 100 shares, and she’ll have to take my loss for me. If I don’t respond to the margin calls, she buys the shares, closes out my position, and makes me take the loss.

I don’t claim to understand non-naked short selling. I imagine it works something like this. My broker gets 100 shares of the stock and gives them to me. I immediately sell them. I promise to buy them back later.

Suppose that I didn’t sell the shares. Suppose I just took shares from my broker, and promised to buy them back later. Then that would be an ordinary repo loan from me to my broker, using the stock as collateral. The difference with short-selling is that I dump the collateral!

With non-naked short selling, my obligation to buy shares is with a specific counter-party, my broker. With naked short-selling, I just have a vague obligation to the “market.”

In my opinion, there is no practical difference between naked short-selling and non-naked short selling.

2. How can short-selling destroy a good company?

The simple answer is that it can’t.

First of all, short-selling can’t force down your share price. Short-selling only forces down your share price if buyers don’t emerge to defend your share price.

Banning short-selling cannot protect a bad stock. If nobody is willing to buy XYZ at a price higher than $.02 a share, then the price at which XYZ will trade will be $.02 a share (or lower). It doesn’t matter whether you have short-sellers or not.

What drives stock prices down is the lack of people willing to buy them at the higher price. If the company has sufficient value, there will be sufficient buyers.