Short selling is a trading strategy where one sells stock on which you don’t intend to make immediate delivery to the buyer. Either because you don’t actually own the stock (uncovered short) or because you own the stock and wish to protect yourself against a drop in the price (covered short). Either way, a broker allows you to borrow the shares to make delivery to the buyer and charges you a finance charge until you cover the short by replacing the stock by buying the shares on the open market or surrendering yours. Profits are made on a short sell if the stock declines (you replace the borrowed shares for less than the sale proceeds) and losses are booked if the stock increases in value from the time of the short sale. There is tremendous risk in short selling because, while the value of a stock can only drop to zero, there is potentially no end to how much it can increase and therefore no bottom to the potential loss on a short position. Short positions can be constructed with just about any security not just stocks. The key issue is finding a counterparty (someone willing to take the “long” side of the trade).
There is a great deal of controversy ( and indeed public outrage) recently surrounding large trading organizations such as investment banks and hedge funds that use short selling as a trading strategy. A short strategy is at the heart of the Goldman Sachs transaction that has landed the firm in hot water. Basically the firm created and sold a pool of subprime mortgages called a Collateralized Debt Obligation (CDO)(the long position) at the request of a client. In fact, the client helped select the loans to be included in the pool. The client then in turn created at short position by buying a Credit Default Swap (CDS) on the same security. The CDS was an insurance agreement with a third party that in the event of the mortgages in the pool defaulting the third party (in this case AIG Insurance) would pay the holder of the CDS the value of the covered security. In other word Goldman’s client was betting that the securities it helped created would default. This is, in fact, a short position. It is important to understand that nothing that any of the firms did was illegal. The SEC’s complaint is that the short interest of Goldman’s client and their involvement with the construction of the mortgage pool was not disclosed to potential buyers of the subprime mortgage pool.
There is something about short selling that causes revulsion in most of us. Most investors will never utilize short selling because they do not have the risk tolerance and in reality no need for the hedge that a short sell offers. A short sell is a bet against something and usually something that we view in a positive light, a company, a country’s ability to repay its sovereign debt, or in the Goldman case, something that Americans hold very dear, home ownership. As much as we dislike shorts, they are a necessary part of efficient markets. At the most basic level every trade requires two parties, a buyer who thinks the security will go up and a seller who thinks it will go down or needs the money for something else. The shorts supply a big enough percentage of the sell side that, if missing, would cause a significant liquidity problem. Also, the ability to sell something borrowed is very difficult to limit without a severe impingement on all of us to dispose of property we own or control. Also many entities including investment banks, farmers, commodities intermediaries, and companies dependent on natural resources for raw materials are forced to take long positions in a great many markets. The only way for these entities to protect themselves against market disasters is to be able to take an offsetting short position. Without this ability these entities would be more likely to fail and indeed, many may cease to exist because no one would be willing to take the associated risks and the economy would suffer greatly.
We must allow short selling but it also must be regulated. From 1938 until 2007 there was a rule that prohibited short sells on stocks unless there was uptick in the price. The purpose of this rule was to discourage outside entities from executing “bear raids” on stocks (a trader's attempt to force down the price of a particular security by heavy selling or short selling). Together with a prohibition against naked short selling (conducting a short sale while neither owning nor borrowing the stock for delivery) these rules created enough risk that short sellers had to be careful about when, what, and how they shorted. The SEC under the Bush Administration abolished the uptick rule and flat out failed to enforce the prohibition against naked shorting. Both rules need to be reestablished and enforced. Another issue is the fact that the most active short sellers are hedge funds, which are exempt from either registering or reporting to the SEC (or anyone else for that matter). As a consequence regulatory authorities have no clue what these people are doing with billions of dollars (and leveraged at 30 to 50 : 1 to boot) and no way to gauge the effect of this trading on markets. This puts you, the individual investor at a tremendous disadvantage. A disadvantage that can be partially rectified by having hedge funds register with and report their activities to a regulatory authority. In the meantime, you as an individual investor need to be aware that these activities occur, we may not like them, but they are required for efficiently functioning markets. It is very difficult for individual investors to muster the resources required to judge the effect that short sellers have, or could have, on the securities they own. That is precisely why I recommend that the large majority of individual investors use mutual funds for their portfolio construction. Professional investors, such as mutual fund managers, have both access to data and the expertise and experience to gauge the effect of shorting on their portfolio positions and perhaps even use it to the advantage of their shareholders.