Does Shorting A Stock Drive Its Price Lower?

Short selling is not a widely understood phenomenon in markets. Some even attach moral or ethical implications to it.

Various executives have come publicly complained about short selling, from Tesla’s Elon Musk to several high-profile frauds and business failures blaming their downfall on short selling, such as Enron, Worldcom, and Wirecard.

We’ve covered short selling previous articles here (overview of short selling) and here (myths about short selling).

But a common question is how short selling actually impacts the price of a stock. Does it drive the price lower?

Short selling and its impact on markets

In general, the accepted wisdom is that while short selling can have an impact on the price of a stock in the short-term, in the long-term it doesn’t have a significant impact.

In the short run, if there is excess sellers relative to buyers, then yes, the price will fall.

This selling can take the form of either: a) owners selling their existing shares (which isn’t short selling) or b) those borrowing shares to sell short.

But over the long run, it shouldn’t make much of a difference.

There are several reasons for this:

1) Short sellers are not always right.

In order for them to make money from shorting a stock, the price has to fall.

But that doesn’t always happen. Sometimes short sellers are forced to “cover” their position by buying back the shares at a higher price, incurring a loss.

And in the long run, they will have to buy back the shares either way. That’s the only way they can close out the position.

2) Short selling tends to pick up when there’s already negativity surrounding a stock.

Sometimes those who join in on a stock’s fall are called “tourist shorts.” They also tend to bail if and when the stock’s price rises again.

So it’s not really clear how much impact short selling has on the price.

3) Short sellers provide liquidity to markets. When a stock is falling and liquidity starts to dry up in a market, short sellers have value in helping match bid and ask prices. (Market makers can fulfill a similar role.)

This can actually function to help to stabilize the price.

4) Over the long run, the value of a business is the amount of cash it earns discounted back to the present.

Markets more or less tend to get things about right over the long run.

While markets don’t price everything perfectly, it is still hard to compete in the markets.

There are very few “no-brainers” in a market and it’s not at all easy to spot an obvious mispricing in such a way as to get easy winning trades.

Executive criticism of short selling

While some executives complain about short selling, most do not.

In the end, most understand that the best way to beat any type of criticism or “burn the shorts” is to successfully build the business.

The better the business and the fairer the stock price relative to the fundamental value of the business, the less short selling there is likely to be.

Short selling bans

In times of market stress, sometimes politicians will ban short selling.

But it doesn’t typically solve anything. If anything, it removes liquidity from a market, which can exacerbate the problem.

The positives of short selling

If anything, short selling helps to balance out perspectives in a market, given how entrenched the “long bias” is in a market from market commentators, sell-side analysts, and those with strong interests in seeing stocks rise independent of fundamental value.

Short sellers can also be highly influential in exposing frauds, investment scams, consumer fads, bad business models, dishonest management teams, and untrustworthy narratives.

The ultimate reinforcement for most people is price action. The more the price of a stock goes up, the more the investing public thinks it’s okay.

This means it’s easier for fraudsters to raise money. And generally they’re not exposed until the cycle turns down because at that point people stop funding them and will want their money back.

Short selling can provide some type of counter to this. Short selling provides information.

And those who go public with their research can help prevent a high level of capital misallocation in bad businesses and expose fraudsters who are simply looking to execute stock promotion schemes rather than real businesses than produce more than they consume.

People, which includes institutional investors and not just individual traders, often end up getting more enthralled with the story than they are with the numbers.

Conclusion

So while short selling can have an impact on the price of a stock in the short-term, over the long term it doesn’t have a significant impact.

This goes back to Benjamin Graham’s concept of “voting machine” versus “weighing machine”.

in the short run, the market is like a voting machine.

This means it’s keeping a record of which firms are popular and unpopular.

But in the long run, the market is like a weighing machine.

This means it’s assessing the actual substance of a company.

The general idea is that what matters in the long run is a company’s actual underlying business performance and not the investing public’s fickle opinion over its short-run prospects.

When the stock market varies significantly in price during the day, does this genuinely reflect the true discounted present value of cash flows?

Short selling’s influence on prices matters in the same way.

It may influence short-run prices to some extent based on supply and demand dynamics in the shares for that particular company. But over the long run, financial performance is what’s most important.