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Is short selling bad?

A discussion of the virtues and/or vices of short selling. Created by Sal Khan.

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  • mr pants teal style avatar for user Nick
    What happens if you short sell a stock, and then the company goes bankrupt?

    If that companies stock disappears for whatever reason, doesn't that mean you effectively aren't obliged to buy a now defunct or 0 value stock for the person you borrowed it from? Would that mean you made a profit from selling an item you never bought or owned at any point?
    (109 votes)
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    • mr pants teal style avatar for user Nick
      Doing a quick web search, it seems to be in fact the case that if the company goes bankrupt and the initial stock holders aren't awarded anything (likely), you will never have to buy the stock.

      Meaning the end result is that you end up making money selling something you never owned.

      How is this meta finance stuff, such as in this case or Credit default swaps when people insure things they don't even own, legal/ethical?
      (63 votes)
  • male robot hal style avatar for user Damian Roy
    Sal, you mention the reduction in volatility brought about by active short sellers. However, the last 2 years have been nothing if not volatile and prior to March '09 short sellers received the blame. Was this due to naked short selling? Could you please explain what that is and how it affects markets? Would you also kindly do the same for High Frequency Trading? I hear it makes up roughly 70% of daily volume but don't know what it is or how it affects things - Flash Crash? Thank you very much!
    (21 votes)
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    • aqualine ultimate style avatar for user Eric
      Naked short selling is selling the stock without actually owning it. In options markets, you can do the same thing, even more dangerously, by selling naked puts or calls. What is effectively happening is you are hoping for a reduction in stock value by any amount (shorting stock) or perhaps just some reduction (in the case of naked option selling) This does increase market liquidity, however brokerage houses will force a short to have a certain amount frozen to cover in the event that the trade goes the other way on them. One cannot, for example, just say "I bet it goes down and I win if it does, but if it doesn't, I don't have the money to pay the losing bet anyways".
      (8 votes)
  • blobby green style avatar for user Aric Diamond
    How does short selling reduce volatility? People who short and long a stock are doing the same thing: Selling High and Buying Low, but just in a different order. If they're both going to sell at a peak and buy at a trough, aren't they just adding to volatility?
    (3 votes)
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    • leaf grey style avatar for user Shlomo Fingerer
      Volatility is caused by having an unbalanced relationship between buyers & sellers. Everyone trying to sell at the same time one day, everyone trying to buy the same stock another day. Having people on the other side of the trade, balances it out, for a more smooth trading pattern.
      (37 votes)
  • piceratops ultimate style avatar for user Yung Black Wolf
    Okay so that whole BL;SH, decreases volatility, while BH;SL increases volatility seems a little funny to me. I mean basically it's saying that no matter what the volatility remains the same, right? Because in order to Buy Low and Sell High, someone else must Sell Low and Buy High. IDk I'm just a bit confused by the redundancy. Can someone please help explain this to me?
    (5 votes)
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  • blobby green style avatar for user krassimir.kostadinov
    It is interesting to see if the same applies when somebody with an insider information is short selling
    (6 votes)
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  • At you mention that those who sell at low points and buy at high points are penalized, but what about those who trade on momentum -- buying and then quickly selling while the market is climbing and, well, short-shorting while it's falling? Don't they drive up volatility by making rises and falls steeper (and thereby more likely to draw in more investors, piling onto the momentum)?
    (5 votes)
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  • leaf grey style avatar for user ross.sj
    What concerns me most about short-selling is that people can make money from destructive activities (terrorists for example could short company before attacking it, and cover afterwards). Is there any real defense against these perverse incentives?
    (5 votes)
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    • leaf green style avatar for user Ryan
      There are just as many ways to manipulate a stock up as there is to manipulate a stock down. Anyone remember the popular takeover rumors from an "Anonymous buyer" that were so popular between 2004-2006? Often times a manufactured short squeeze higher is far more violent than a manufactured sell off. But in the end the net result of short selling is beneficial to the market. If you are the CEO of a large corporation, you have access to all sorts of business opportunities. Some may be more legitimate and legal than others. If you know that people will actively try to get rich off of your mistakes, it changes how you make business decisions.

      But, Andrew is right about the terrorist thing. There are large lists published by the government with every terrorist and known alias which are distributed to every financial institution. And each institution is required to sign off stating that no one on the list has an account at that institution.
      (3 votes)
  • leaf orange style avatar for user Josh Claar
    I would be very curious about some of the market manipulation, and what goes on there.
    (3 votes)
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  • blobby green style avatar for user andrew.m.freire
    Then isn't it theoretically possible for a really talented investor/shortseller then, to make money at all times, regardless of if a stock is doing well or not?

    For example, let's say an investor could see the future and bought stock at a low price, then sold at a peak. Then they initiate a short sell immediately at the peak and buy back when the stock is low again. They immediately take the money they made from the short sell and buy stock again just before it rises. In essence, they are profiting from a company at all times, even during economic loss.

    Now let's assume many people could do this. Wouldn't you basically be generating money where there is none, and therefore causing inflation?

    It seems like economic manipulations like this (creating money where there was none before) is what leads to economic collapse/recession.

    Of course, that is an extreme example. Banks giving out high risk loans and credit are probably more to blame for creating inflation. But I'm new to economics, so maybe I'm completely wrong
    (3 votes)
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  • blobby green style avatar for user lorenzo
    Is there any empirical research that I can look at and that back these statements regarding the incentives of short sellers and other market operators to disclose info on stocks or are they just the result of common sense reasoning?
    (5 votes)
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    • blobby green style avatar for user dserv7
      It's common sense, but I'd like to see any studies that have been conducted. It's hard to think of how you would conduct such a study. As Sal points out in the video, nearly the entire investing world (and people outside of the investing world as well) are on the positive side. Hard to get a basis of comparison in terms of what constitutes someone pumping/not being critical of a stock when the whole world is oriented that way. Could be a little tricky in terms of methodology... but would like to see if anyone has sources?
      (0 votes)

Video transcript

I think we know enough about shorting now that we can start thinking about whether it's a good or bad thing to have in financial markets. And what I've done here is I've drawn a hypothetical stock chart for a company. This time right here. This is the price of the company. And let's just say that this is a chart in a universe that doesn't have short sellers in it. So this is all-- here a lot of people are buying the stock, then over here some people, maybe they get freaked out or whatever, they start selling. And then more people buy. So demands a little higher than supply, so the price goes up. And that just generally drives the volatility. Now in a short selling world, what would happen? Let's let's think about two scenarios, a short seller who makes money, and a short seller who loses money. So a short seller making money. What would a short seller making money have to do if this is the stock chart. Obviously, they don't see the stock chart beyond the day that they're actually making the trade, but in order to make money they'll actually-- they'll have to short at the local peaks. And they would have to cover their shorts at the local minimum. So a good short seller-- or you can even say a perfect short seller would maybe short here-- let me make it a different color so you can see where he's acting-- would short here and then cover there. And he would make that much money on that move. And then he would wait a little bit, wait for the stock to get expensive again in his mind. And he would short here, and then he would cover here. This would kind of be-- obviously it's very unlikely that someone could so well pick tops and bottoms. But let's say they're just really good at their analysis and figuring out market psychology and things like that. And they would just keep doing it. They would short here and cover here. What would that actually do to the stock? The green line was a reality where you had no short sellers. Now if all of a sudden you allowed short selling, and they had these guys come into the market who know how to make money shorting. He's shorting up here. So what would shorting do? Shorting is you're borrowing the stock and selling it. So he's creating extra supply for the stock, right? So what he would be doing at this point, by shorting, is he would actually be lowering the price at this point. So let me draw the curve. So if there's a bunch of short sellers acting in this range, it would actually lower the peak. Because you have a bunch-- you have some more aggregate sellers. So the price wouldn't go as high. And then on the other hand, these short sellers have to cover right here, right? They're going to cover their position. So at the low point you have more aggregate buyers covering a short position, is just you're buying the stock to pay it back, because you borrowed it earlier. So here you would have more aggregate buyers. And then at this point, once again you have more aggregate sellers, so the price won't go as high. You have more aggregate buyers here, because the short sellers need to cover, so the price won't go as low. And so forth and so on. And the bottom line is, a short seller who's making money on the stock market, so they're shorting the stock at peaks and covering the stock at troughs, is actually reducing the volatility of the stock. And that's good for everybody. That's good for the company's management. That's good for the actual shareholders of the company. And obviously it's good for the short sellers because they are actually making money. And this is actually true for anyone making money in the stock market. That they're reducing volatility. What is a long-- just a regular investor-- or I guess you could call them a trader since they're buying and selling-- a regular trader would make money by buying here and selling here. So really a regular trader is not any different. A regular long trader is no different than a short seller, it's just the order in which they're buying or selling. But anyone making money is buying at low points and selling at high points. And anyone doing that is helping to reduce the volatility in the stock. And even if you're a long term buy and hold player, you would rather sit and hold a stock-- you would rather be a holder of a stock that does this, than a holder of a stock that does this. Now there are a lot of players both on-- you could call them traders because they're buying and selling on a regular basis-- that aren't kind of doing this. Maybe they're piling on the shorts at a low point and they're causing the stock to go down even more. And then, when the stock starts to move up they get scared and they buy it, and it causes the stock to move up even more. And it increases the volatility of the stock. But these guys are being penalized because they're losing money. The people who sell at low points and then buy at high points, and increase the volatility, they're getting killed. They're falling every day. So it's not like you have to create some penalty for those guys. Their penalty is that they're just bad traders, they're bad investors. And they're just going to lose their shirts. So if you're assuming that none of these traders in any way manipulating the markets or spreading false rumors. Anyone making money on a stock, as long as they're not manipulating it, on either the short or the long side, is actually a net asset for the stock. That they're actually reducing the volatility of the stock price. I guess another thing to think about and this is just from a-- it's good. They're reducing the volatility, so from that point sorting doesn't seem too bad, for me, or in general to the market. But another way to think about it is, kind of where are all the incentives in the markets? Who has an incentive to be positive on a stock? And who has an incentive to be a negative on a stock? Or to scrutinize a stocks? Well, the biggest, I guess cheerleaders, for a stock, and it depends on their degree of kind of credibility or ethics, would be the company's management, right? These are people-- it would be company's management. These are people who obviously run the company, but they have the best transparency into the financials of a company, and they tend to be shareholders of the company or get compensated based on how the stock does. So these guys have every incentive to be positive. And, as we've seen multiple examples of, whether you're talking about the investment banks, or Enron, or Accenture, they'll often kind of hide the truth when things get bad. So these guys are definitely big time positive on stocks. Then, let's see, who are the other players or the influencers on financial markets? Well, a big one is the financial press. And I'll write it out here so we can have a discussion about whether they are pumpers of stock or whether they tend to be more-- whether they tend to scrutinize things a little bit more. An important thing to think about with the financial press, and next time you watch CNBC-- and I don't want to just pick on them-- is how do they make money? Do they make money by finding things that are wrong with companies? Do they make money by making you money? No, they make money by selling ads. And then the next question, obviously, is who are they selling ads to? Are they selling ads for mops? Are they selling ads for bicycles? No, they're selling ads to financial services companies. So people who want to manage your wealth, stock brokers, mutual fund companies, anyone who can advertise. And this is key, too, because-- I don't know, you're probably not aware of it but hedge funds can't advertise, so they're not consumers of the financial-- or they're not customers of the financial press. The only people who are customers of the financial press are money managers, financial planners, and things like that-- brokers, mutual funds. And all of these guys benefit when stock markets go up. Obviously mutual fund managers will-- they tend to be long only, so they only want things to go up. Stock brokers-- you might say, oh you know, a stock broker can advise you to go long or short and they just care about how many transactions you make. But in general, more and more people put money into the stock market in rising markets. In a market like you're seeing right now over the last year, people are pulling out-- you could say oh, maybe people aren't doing more transactions, but the general net effect is, people are pulling money out of the markets. So when they're pulling money out of the markets, brokers are getting less transactions, they're managing less money. And that's also true of the money managers. And there's also just another ancillary side effect, is when markets go down and people become less excited about the stock market, people stop watching CNBC and CNNfn. And so even those few ads that are for mops and for bicycles and for cars will get fewer viewers. So in general the financial press, at least in my opinion, is squarely in this camp. And then we can talk more, you know, sell side analysts. You've probably heard the term sell side and buy side. But sell side analysts are the analysts that work for the major brokerages and investment banks, who publish those reports that you see in those ratings, a buy rating on IBM, or whatever. And the reason why they call them sell side analysts is because they work for the people who are essentially, on some level, selling-- you could either view them as they often offer securities, or they offer financial services to, often the companies themselves, or to potential acquirers of the companies. Or they're selling their services-- I mean, usually-- they're brokerage services, so they're trying to get people to transact, they're actually brokers on some level. But clearly these guys, their incentive, since their customer tends to be the management of companies, is to be very, very, very positive. And you should say oh, there are other people who, their whole job is to scrutinize these people. Like, the government. But if you think about it once again, the government likes a rising stock market. It takes-- when people's 401k's are rising, the economy does better, the government doesn't have to worry as much about other types of social benefits, and unemployment, and things like that. So in general, and if you want to be more, I guess, if you want to be more critical of the government, you could also say that they are, to some degree, very close to the management of these firms and to financial companies. And to some degree, these guys have significant clout in terms of lobbyists-- and, well actually, I would even say the bankers, too. They have significant clout in terms of lobbying, and just access to government, generally. And government drives the regulators, so these guys are also on the positive camp. And then finally you have the ratings agencies. And the ratings agencies mainly operate in the debt world. And we'll talk more about that. But, if you can scrutinize a company on the debt level, and you say oh wow, this company really isn't that good, they're not going to be able pay off its debt. That kills the stock. But once again you have to realize that the rating agencies are also paid by the bankers, so the rating agencies are also-- have the incentive to kind of not see things when things are bad. So out of everyone in the financial services, or the financial world, that we've talked about right now, they all benefit when stocks continue to go up. Even when they go up beyond what they really should go up. And even if they all kind of know that things are a little bit too expensive. Or this management team might be a little shady, or they might be covering up something. None of these people really have an incentive to expose it. And the only people who do are the short sellers. These are the only people who really have, arguably the sophistication and the time and the monetary incentive to really look and scrutinize what management is doing. To really look in the books and kind of put a puzzle together, or put a bunch of pieces together to come to the conclusion, wait, the numbers that management is spouting really don't add up. And because of x, y and z, this company really is overvalued. So to a large degree they are kind of on society's side in preventing management from kind of being overly bullish. And I don't want to sound like someone who just broadly is defending short sellers. There is a class of short sellers that I think would be bad, and that's the people who are spreading false rumors, and being market manipulators. So there's just the general market manipulation, or rumor mongering. And that definitely is bad, and to some degree, if you can show someone is doing that, there should be some type of penalty for doing it. But even there, and just it in my experience participating in public markets, if I had to pick-- if I had to pick between the left side of that chart, between this side of this charge and this side of this chart-- and if I had to say who does spread false information when it does get spread? I think often times management is a little bit more guilty of it than the short sellers. In fact there's very few times that I've seen where the short sellers are-- there's some negative thesis on the stock and where it really comes out to be completely untrue. Although, there are examples, and those short sellers, I don't think are really in the mainstream Anyway, I don't want to meander too much. I realize that this video has already gotten long. But I thought it's a nice, useful discussion to maybe think a little bit about whether short selling really is all that bad, even if you are a long investor.