Short selling improves markets

Short selling improves stock markets with liquidity, price discovery and activity that can also improve some shareholder values. Short seller pressure has made managements more accountable as well as sensitive to public, employee and shareholder issues. That pressure has made management of some companies more receptive to contrarian views or analytics.

Does short selling hurt markets?

Short Story Shorting Stocks course, Lesson 2, answers the question, does short selling hurt markets? At the end of the lesson, links to related content help you learn more.

What you learn:

The lesson explains how short selling improves market liquidity, price discovery and market activity. As well you learn how markets improve as shorting pressure improves companies. You also learn how understanding this sophisticated strategy can improve your investing results.

How short selling improves markets

Short selling activity improves stock markets in ways that benefit all investors. Understanding the forces involved increases your knowledge of the overall investing scene. Short selling brings benefits that help create a healthy and efficient stock market. That benefits all investors, short or long, and the economy.

Downward price pressure from large short positions remains the most obvious market force of short selling. Such price pressure can quickly erode share values of the company under attack.

This can happen once long investors get worried that the short seller could be right by knowing something that they do not. On the chance that the shorts are right, some shareholders may begin selling.

Some sellers tiptoe towards the exit, but others completely and quickly bailout of their entire positions. Once the selling volume accelerates the downward price, this can quickly cascade into panic selling.

Any significant increase in selling volume can tip the price scale. Once more investors wish to sell than to buy, share prices can dramatically plunge. Still, this short selling activity brings positives to stock markets.

Shorting activity that improves markets:

1. 1. 1. Liquidity Increased

      2. Price Discovery Improved

      3. Increases Market Activity

Short selling adds liquidity

Any new buying or selling that comes into a market adds liquidity. Short selling does that by adding more volume above the normal levels. Like any increase in volume, short selling activity adds liquidity. That volume would not be there without the short sellers.

Shorts improve price discovery

Price discovery is the essential pricing mechanism of a normal market. The market seeks a price that willing buyers and willing sellers agree on. Discovering or finding a price that balances buyers, sellers and volume triggers each transaction.

Basic supply and demand forces move prices up and down until buyers and sellers agree on a satisfactory or acceptable price for a given quantity. If one side or the other has more demand or supply, the price shifts to bring balance. That point of balance is the “discovered” price.

Selling pressure pushes markets

Short sellers enter this mix by initially adding selling pressure. Their selling brings more supply. That can begin the process of forcing prices lower.

Should enough new buying emerge in response to the increased supply, little price change happens. As long as the number of shares being sold gets absorbed by an equal amount of new buying, prices remain stable.

However, should little or no more buying occur, the stock price falls. It will decline to the price that attracts enough buying to balance the selling pressure. In that way, short selling activity helps “discover” the new and correct lower price.

Be mindful, that, at sometime in the future, a short seller has to cover or buy back the same amount that they have sold. At that time, their activity will be on the other side adding buying pressure. And at that point their buying pressure can push prices up.

At some future time, short sellers have no choice but to become buyers. They must produce shares covering their loan to close their position.

Shorts increase market activity

Markets and investors in stock markets usually welcome any increase in market activity. The more the merrier typifies attitudes. As volume and broad based trading activity increases, all aspects of stock market activity function best. Indifferent or agnostic markets view all activity as positive. From the market point of view, more is better.

However, in illiquid or inactive markets or stocks, stirring up activity can produce dramatic price movements. In particular, short activity can bring dramatic price movements in quiet or sleepy markets.

At times, quite slumbering stocks get stirred into action by short selling. However, shorting in a quiet market is very risky compared to more liquid and active markets. But short selling may bring market and media attention that stirs activity. A comatose stock can quickly erupt into a buying or selling frenzy in moments. The downside of that risky move is, instead of waking up a sleeping stock, the short sellers money gets put to sleep!

Contrarian short seller views get broadcast

Most successful major short sellers are a boisterous bunch that release and share their research and opinions freely. Of course, that is after they have quietly taken their short positions. As people with a different opinion, angle or point of view on a stock or markets, they are frequent media darlings that get lots of help to spread their point of view.
That great marketing and messaging activity often stirs market interest and moves prices. This aspect of short selling gets further discussion in a later lesson.

Question Answered!

The lesson answered the question, does short selling hurt markets? It explains how short selling improves market liquidity, price discovery and market activity. We also understand short pressure that improves company performance also makes markets better. The lesson also teaches that understanding short selling can improve investing results.

Lesson takeaways,
Short selling improves markets:

Short selling improves stock markets with liquidity, price discovery and activity that can also improve some shareholder values. Short seller pressure has made managements more accountable as well as sensitive to public, employee and shareholder issues. That pressure has made management of some companies more receptive to contrarian views or analytics.

• Short selling increases stock market liquidity.
• Price discovery is improved by short selling pressure.
• Short selling increases market activity.
• Marketing and messaging activity of short sellers stirs market interest.

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Comments and questions welcome

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Short story shorting stocks:

Short selling stock explained Lesson 1

Short selling improves markets Lesson 2

Short selling improves companies Lesson 3

9 Short seller facts align Lesson 4

Making money selling short Lesson 5

Shorting stocks has risks Lesson 6

Who’s selling your stock? Lesson 7

Short seller skill sophistication knowledge Lesson 8

Short seller cost control Lesson 9

Short selling has rules Lesson 10

Next lesson 3:
Short selling improves companies

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