Recent events surrounding meme stocks and GameStop’s short squeeze have put short selling, one of the oldest practices in the stock market, straight into the spotlight.
“Short selling has always been around,” said Ihor Dusaniwsky, managing director of S3 Partners, a company specializing in analyzing short sale data. “It has been part of the normal process of trading on the exchanges since the inception of the exchanges. We have recently seen an increase in short sales in a wider range of names.”
Short selling has always been a controversial practice, often accused of causing declines in the market. The Securities and Exchange Commission eventually stepped in to better regulate short selling after short sellers were again accused of a market downturn in 1937.
“I think the main reason people don’t like short selling is that something feels bad about taking advantage of someone else’s failures,” said Sasha Indarte, assistant professor. of Finance at the Wharton School at the University of Pennsylvania. “Short sellers win when someone else loses. It’s like taking out an insurance policy against your neighbor’s house and your neighbor’s house is destroyed.”
Short selling is when investors, mostly professionals like hedge fund managers, borrow a stock from a stock broker and sell them in the hopes of buying them back for less. If the stock goes down, investors make a profit on the difference when they return the stock to the broker. Short squeeze occurs if the price goes up and investors have to rush to buy the stock to cut their losses.
Countries in Asia and Europe have banned short selling in times of economic uncertainty. However, some studies have shown that a ban on short selling does more harm to the market than good.
“During the financial crisis between 2007 and 2009, regulators actually temporarily banned short selling in response to sharp declines in the stock market. Regulators have since expressed regret for this political action,” said Mr. Indarte.
Indeed, despite the negative feelings towards it, short selling plays a central role in the market. For example, short selling enables more accurate price discovery, a key function of the stock market.
“Without the short sellers, there would be a lot of long-time shareholders buying and bidding on stocks that really had no value,” Dusaniwsky warned.
Short selling has also enabled early detection of fraud.
“There are companies that don’t do the right thing, engage in fraudulent practices, and short-selling a stock often brings some of these things to life,” said Jason Snipe, founder and chief investment officer at Odyssey Capital Advisors.
“People don’t get upset when they make money on the rise. They are turning their eyes away from bad corporate behavior, ”argued Jim Chanos, a prolific short seller in the US market. “But when people start to lose money, they get mad.”
However, in light of recent events, experts warn that social media and “memes stocks” could lead to changes in practice. And recent data shows hedge funds have drastically reduced business due to the threat of getting caught on the wrong side of the business by a retail mania.
“Going forward, with the advent of social media and some of the other media that people watch these days, the SEC probably needs to be thoughtful and reasonable here,” Snipe said. “And I think they will be as far as their review of how we watch short films in the future.”
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