Short Selling and the Price Discovery Process (2024)

FAQs

What are the arguments for short selling? ›

Proponents argue that short sellers can add liquidity, reveal stocks that are priced higher than their actual worth, and help bring their prices closer to their true value.

Short selling involves borrowing a security whose price you think is going to fall and then selling it on the open market. You then buy the same stock back later, hopefully for a lower price than you initially sold it for, return the borrowed stock to your broker, and pocket the difference.

Short selling occurs when an investor borrows a security and sells it on the open market, planning to repurchase later for less money. Short sellers bet on and profit from, a drop in a security's price.

It is widely agreed that excessive short sale activity can cause sudden price declines, which can undermine investor confidence, depress the market value of a company's shares and make it more difficult for that company to raise capital, expand and create jobs.

To sell short, the security must first be borrowed on margin and then sold in the market, to be bought back at a later date. While some critics have argued that selling short is unethical because it is a bet against growth, most economists now recognize it as an important piece of a liquid and efficient market.

The traditional method of shorting stocks involves borrowing shares from someone who already owns them and selling them at the current market price – if there is a fall in the market price, the investor can buy back the shares at a lower price, and profit from the change in value.

Why is naked short selling illegal? Naked short selling is illegal because it involves the selling of securities that the seller does not actually own or have borrowed, which can result in a lack of sufficient supply of the securities in the market and potentially lead to a decline in the price of the securities.

The short seller usually must pay handling fee to borrow the asset (charged at a particular rate over time, similar to an interest payment) and reimburse the lender for any cash return (such as a dividend) that was paid on the asset while borrowed.

How does shorting work for dummies? ›

You immediately sell the shares you have borrowed. You pocket the cash from the sale. You wait for the stock to fall and then buy the shares back at the new, lower price. You return the shares to the brokerage you borrowed them from and pocket the difference.

Short selling is a contentious practice. First, it can hurt markets, companies, and investor sentiment. There is also the potential for market manipulation. Aggressive short selling can have a major effect on the companies being shorted.

Short Selling Example

You take a short position on XYZ and borrow 1,000 shares of the stock at the current market rate. Five weeks later, XYZ stock falls to $25 per share, and you buy the stock. Before taking out any brokerage fees associated with the short, your profits are $10,000: ($35 - $25) x 1,000.

The maximum profit you can make from short selling a stock is 100% because the lowest price at which a stock can trade is $0. However, the maximum profit in practice is due to be less than 100% once stock-borrowing costs and margin interest are included.

If the shares you shorted become worthless, you don't need to buy them back and will have made a 100% profit. Congratulations!

efficient market is a fair price, hence short- sellers may be seen as assisting the process of price discovery and what the market should pay for a company's shares. If listed share prices are perceived to be too high, a market that enables shorting should move more quickly and efficiently towards fair value.