Why Short Sellers Are the Heroes of Wall Street

| About: ProShares Short (SH)

I'm expecting a lot of nasty e-mails on this column, but the truth needs to be told. Short-term traders, especially short sellers, are often blamed erroneously for manipulating stock prices, forcing them down far below their real value, and for creating crashes and general chaos on Wall Street.

In fact, short sellers have been identified as so vile by SEC Chairman Christopher Cox that he has banned short selling for some 980 publicly traded companies. Chairman Cox and other critics of the market blame short sellers for several grievances:

  • Short sellers destabilize prices in a shaky market, and in a panic can make matters worse, causing a crash.

  • Short sellers artificially engage in "bear raids," where traders gang up on an illiquid - or thinly held - publicly traded company and push the price way down below their intrinsic value. After the stock plunges, traders cover their shorts and buy up good companies at bargain prices.

By temporarily banning short sales, Chairman Cox hopes to prevent the stock market from declining further. (So far he has been unsuccessful.)

So who's right, the short-selling proponents, or Chairman Cox? The best way to determine the truth is to look at what short selling is, and the evidence on what it does.

What Exactly is Short Selling?

Short selling is a way for investors and speculators to bet on falling prices, and for long-term investors to protect their investment portfolio during a bear market.

Most investors profit from stocks by buying a stock and then selling it when the price goes up. Short sellers do the opposite. They sell a stock first and then buy it back when the price goes down.

  • Short sellers accomplish this by borrowing the stock first and then selling it. To close their trade they purchase the shares, hopefully at a discount. When they buy the stock back, they return the borrowed stock to the owner and pocket the profit from the difference in price. Short sales must take place in a "margin account" because the sellers are using borrowed money.

  • "Naked" short selling is more controversial. It's defined as a short sale by brokers/dealers who sell a stock short without borrowing it first. The SEC recently banned this practice as well.

  • Investors can also sell short a stock that they own. This is the least controversial technique. It's often used at the end of the calendar year to lock in profits in a stock that has gone up in price.

But with the potential positive and negative aspects of short selling, what do the facts from the scientific community show?

Adam Reed, a finance professor at University of North Carolina, and Arturo Bris, a finance professor at Yale, have done extensive studies on short selling. He has come to the following conclusions.

  • On bear raids: "In recent years, when academic researchers have looked for bear raids - even in those areas in which investors suspected that they existed - they haven't found them." They couldn't even find evidence of bear raids on 19 beleaguered financial stocks. They conclude that short sellers reacted to downward momentum, rather than caused it. "Typically, short sellers trade in response to past negative news," Professor Bris said, "rather than inducing current stock price drops." (Note: While bear raids are unlikely in mid to large companies because of their size, I do think that short sellers can artificially manipulate small-cap and penny stocks. I've seen it too many times!)

  • On short selling causing greater volatility: Professor Reed found just the opposite, that "stocks without short selling not infrequently trade at prices that deviate widely from their true value."

3 Major Advantages of Short Selling Stocks

Academic studies also show three major advantages of short selling stocks:

  • First, they counter the "irrational exuberance" that company officials and bullish promoters parade about their stocks, and encourage a more sensible valuation of a company's worth.

  • Second, short selling is a legitimate way to hedge your position. It is not simply a strategy to profit from falling prices. Major institutions and conservative investors often use short selling to lock in a position for a period of time, and protect themselves from downside risk.

  • Third, short sellers and short-term traders provide extra liquidity and thus reduce bid-asked spreads. It is short-term speculators that allow long-term investors to sell when they want to.

From a practical point of view, while short selling of individual stocks is temporarily prohibited, investors can still play the down side of the market by buying short exchange-traded funds (ETFs), such as SHORT S&P500 PROSHARES (NYSEARCA:SH).

Professor Bris concludes with this word of caution: "The ban on short selling may prolong the crisis in the sense that it will now take the markets longer to adjust to the true values of financial companies."

Short sellers and speculators are in fact helping us make the markets more efficient and more profitable for investors. In today's market environment we can use as many of these heroes as we can get.

Let's hope Chairman Cox comes to his senses and reverses his ban on short selling soon.