I was planning to talk further about the investing plan today, but a story today about a new book coming out, “The Big Short” by Michael Lewis on NPR made me decide to post a commentary in defense of short selling instead. One can read about the book on NPR’s website:
I have been short at various times. Short sellers are demonized in general by society as somehow anti-capitalist, anti-society, and even evil. When you buy long, you are “injecting capital into the financial system and supporting free enterprise”. When going short, you’re “hoping that others will lose and companies will fail and people will be out of work”. Even the IRS treats short sellers differently, in that a short sale is considered a short-term gain and taxed at the higher rate no matter how long it is held open (check this, I’m not an accountant).
Let’s look at really what is happening when someone goes short. In a (legal) short sale, an individual calls his broker and asks to short 100 shares of XYZ at $100 per share, say. The broker goes out and finds some shares of XYZ to borrow. These generally come from accounts in which the owner is currently in margin (see your account agreement). The broker then sells the shares at $100 and deposits the funds in the investor’s account. If the investor spends any of these funds to buy stocks or to buy dinner or anything else while the short sale is still open, the broker will begin to charge margin interest on the cash spent. In addition, if the stock that is shorted pays a dividend, the person who shorted the stock is responsible to pay the dividend to the person from whom he borrowed the shares (who probably doesn’t even know the shares have been borrowed).
The investor makes money if the stock falls and he is able to buy the shares at a lower price and return them to the person they were borrowed from. For our example, if XYZ falls to $50 per share, the investor could buy the shares back and make a profit of $5000. That is (100 shares) x( $100-$50) per share. If the stock rises, the investor will owe more and more money, and will need to add cash to the account or pay margin interest. For example, if XYZ rose to $150, the investor would now owe $15,000, with $10,000 in the account from the short sale, and need to pay interest on the extra $5000. If the position were closed the investor would lose $5000, plus brokerage fees, plus any interest and dividends paid. When short selling, if your wrong, you pay and then some.
Now let’s look at the ethics of short selling vs. buying long. Here I’m talking about honest short selling, not market manipulation which is illegal and immoral on either side of the trade. Let’s say that an investor feels the market is way too high (for example, at the height of the dot-com bubble), and thinks that it is ridiculous that a new internet company is trading at $300 per share even though they have no profit, are losing money on each sale due to free shipping, and their business plan is to become as big as fast as they can and give new mansions to the founders. An investor may determine that it is far more likely that the market will fall, because the dot-com craze has caused everything to shoot up, and knows that his oil stocks will probably be taken down along with the overpriced dot-com stocks because everything gets sold in a panic. He therefore decides to short some shares of the dot-com as a hedge to offset some of the losses he may experience on his oil stocks.
He is selling the stock short because he sees that the price of the dot-com stock is way out of line with any fair value. He did not drive the prices up to the high levels. He simply noted that the price currently being requested (the “bid”) is way out of line. If he makes money as the stock falls to fair value (and probably a bit below, because these things always overshoot), it is because there was no one left to buy at the outlandish prices, not because of his action.
Now let’s look at the long side. Let’s say that a stock has fallen to almost nothing (look at AFLAC a year ago December) and an individual correctly realizes that the stock is way under fair market value. She goes in and buys $100 shares for $10. Within a few months, the stock has recovered and is selling for $30 per share.
In the case of the short seller, he sold the shares to another individual who was thinking that the stock was going to go dramatically higher (because it had been for the last year). This was another adult who made a decision to buy the shares. This is not taking capital away from the company anymore that buying a used Toyota instead of a used Ford gives money to Toyota or takes money away from Ford. Yes, in order for the short seller to make money on the stock the person who bought it from him would lose money, but in the case of the buyer of the depressed stock if she makes money the person who sold the stock to her probably lost a lot of money because he was willing to sell at such a discounted price, and in any case the buyer paid the seller way less than the shares were worth. (Think of buying a Monet at a yard sale for $5?)
In summary, selling short when a stock is high is no more anti-social than buying a stock when it is depressed. It really is no different from buying a stock low and selling it at a ridiculously high price just before the stock drops. When investing, particularly when speculating and buying for the short-term, everyone is taking a risk.