17+ Reasons Why Short Selling Is Important in Financial Markets
Many market participants have negative opinions of short selling, but it’s essential to healthy, functioning financial markets.
In this article, we explain the various benefits of short selling.
1) Hedging and Risk Mitigation
Short selling is an important form of hedging. It can be used by market participants to reduce their exposure to risk, such as the risk of price declines.
For example, a farming business knows its revenue is essentially price multiplied by volume.
Prices can move around a lot, so farmers will typically want to hedge this risk.
They can do so by shorting a futures contract at the point where they expect to sell their harvest. (They can also use options.) That will lock in their price as they are already “long” the physical market.
When price is predictable, the business is essentially based on volume. While harvest yields can also be impacted due to a variety of factors, it is generally more predictable than price.
If farmers know their acreage, they generally know their expected volume.
Overall, this helps mitigate the risks associated with what they produce or sell.
According to the US Dept of Agriculture, 47,000 farms use futures and/or options to hedge against falling prices.
2) Market Makers Need to Short to Provide Liquid Options Markets
When somebody buys a put option to hedge against falling prices or to short something in a limited-risk way, market makers (often the entity selling the option) need to short the underlying based on the delta and gamma of the position in order to hedge this downside exposure in case the option lands in-the-money.
The greater the moneyness of the option, the more they need to short. The opposite is true of call options.
If shorting was not permitted in markets, options liquidity would dry up significantly.
Shorting is borrowing.
For example, when an American takes out a mortgage, he or she is short the US dollar.
But they’re taking those dollars and buying something with them.
So the shorting (borrowing) that’s involved is just a circulation of capital.
Moreover, when a trader shorts a stock, they receive a cash credit, which can then be used to offset borrowing interest elsewhere or use it to buy something else (subject to margin restrictions).
4) Basis Trades
Short selling is also used in what are known as basis trades.
In a basis trade, one party can hedge itself against potential losses from changing market conditions (such as the aforementioned farmer hedging against a fall in prices from an anticipated future sale) while the other party could potentially profit from these changes.
For example, when a corn farmer shorts corn to lock in the price, the opposite side of the trade could be a trader or investor who wants exposure to the corn market. Each side gets what they want.
5) Price Discovery
Short selling is important because it helps with price discovery – the process by which buyers and sellers determine the value of a particular asset.
When selling short, participants are providing an indication of how much they believe an asset’s price should be in the future. As more people take positions on either side of the market, it will become easier for buyers and sellers to determine a fair price.
This price discovery process helps ensure that prices are based on real demand and supply levels.
6) Benefits Market Liquidity
Short selling also helps to increase liquidity in financial markets.
When traders and investors take short positions in stocks or other instruments, they are essentially providing more shares of a particular asset to the market through the borrowing and lending process.
This increased liquidity means that buyers and sellers can easily enter or exit their positions, reducing the risk of large price swings due to a lack of optimal liquidity.
7) Only Betting on “Up” Is Not Healthy
Bubble conditions can develop when there are too many buyers and not enough sellers.
When someone buys a stock, the company has to produce earnings in order to make due on that claim.
When prices get too high, it’s like any other form of indebtedness. When prices are high and unsustainable, then an eventual wipeout of wealth (to some extent) to get back to healthy fundamental values will eventually occur.
Moreover, short selling helps investors diversify their portfolios by giving them access to returns streams that may not be available through other methods.
This ability to diversify increases investors’ chances of achieving higher returns in the long run.
9) Important source of returns
Short selling also enables traders and investors to generate income or profits when the market is declining by taking advantage of falling prices.
This can be especially helpful for hedging strategies, as it allows investors to offset losses on long positions with gains from short positions.
11) Wealth preservation and creation
Short selling can be used to protect an investor’s wealth from falling markets. By taking a short position in a security, investors are able to minimize their risk and limit their losses if the price of that security drops.
As such, it is another important tool for preserving wealth during more volatile market conditions.
This type of trading can also be used to take advantage of market inefficiencies and make profits by exploiting gaps in pricing. This helps increase the overall liquidity and efficiency of markets, which ultimately leads to healthier markets overall.
For example, pension funds that have access to alternative investments that have positive long-run returns and no correlation to traditional equity and bond investments can help preserve and create wealth for their clients.
Moreover, in the example of a market maker shorting as a way of hedging, this facilitates the buyer’s purchase of the put option, and the market maker increases liquidity in the market and helps reduce transaction costs for all market participants. Everybody is getting what they want.
12) Exposing bad actors
Short selling can help expose bad actors in financial markets. By shorting, investors have the incentive to detect and expose fraudulent accounting and other misleading activities by publicly traded companies.
Many stock promotions and financial frauds have been exposed by short sellers.
This can help prevent the misallocation of capital into bad companies.
Can Alert Regulators
Short selling can also be used as a tool for alerting financial regulators to potential fraud or manipulation in the market. When investors take large and sudden short positions in a stock, it can signal that something may be amiss with the company and prompt regulatory action.
This type of trading activity can serve as an important warning sign for other investors and lead to corrective measures from authorities. As such, it is another way that short selling may help promote fairness and integrity in financial markets.
13) Improves the Allocation of Capital Across Assets, Asset Classes, and Economies
Short selling also improves capital allocation, as it enables investors to reduce their risk by diversifying across different assets and asset classes.
By allowing traders to take short positions in particular securities or sectors (e.g., relative value trading), they can better manage their risk and ensure that capital is being allocated more efficiently across different markets and economies.
14) Arbitrage Trading
Shorting is important in arbitrage trading, as it allows traders to take advantage of pricing discrepancies between two markets. By shorting in one market and going long in another, they can exploit these mismatches and generate profits from the difference in prices.
This helps ensure that capital is flowing towards its most efficient use as quickly as possible, which helps promote market efficiency overall.
15) Restore Healthy Financial Equilibriums
Consider the example of a central bank needing to devalue its currency (e.g, effectively shorting its currency).
Currency devaluations can be a useful tool for a central bank to restore healthy equilibriums in the economy when it’s done in the appropriate way to reduce inflationary pressure and restore a two-way market.
When a currency is devalued, it becomes cheaper relative to other currencies, making the country’s exports more attractive and competitive in foreign markets.
This can lead to an increase in exports, which in turn can help to restore the balance of payments, as more money flows into the country through trade, leading to less of a trade deficit or more of a trade surplus.
For example, suppose a country’s currency is overvalued, causing its exports to become more expensive for foreign buyers. This can lead to a decline in exports, which can put pressure on the balance of payments via a worsened current account.
In this situation, a central bank may choose to devalue the currency to make exports more competitive, which can help to boost exports and restore a healthy balance of payments – either a surplus, balance, or a deficit that can be adequately funded.
In the long run, prices that are out of whack with the economic fundamentals will eventually be restored one way or another. If a currency is overvalued, it will become less competitive in global markets, leading to a decline in exports and pressure on the balance of payments. Eventually, the currency will need to be devalued to restore competitiveness and balance.
Therefore, currency devaluations can be a useful tool for a central bank to restore healthy equilibriums in the economy, but they must be used judiciously and in conjunction with other policies to ensure a stable and sustainable economic environment.
When George Soros famously shorted the British pound in 1992, there was no evil associated with that. It was simply Soros and his investment team realizing that something wasn’t sustainable and that a fall in the pound was simply a self-correcting mechanism because of the prevailing economic fundamentals at the time.
16) Pricing Efficiency via Pair Trading
As mentioned, short selling is important for pricing efficiency in markets because it enables investors to profit from overvalued stocks or assets, thereby promoting market equilibrium.
By allowing investors to bet against the stock or asset, short selling provides a mechanism for negative feedback that can prevent irrational exuberance and speculative bubbles.
This helps to create a more accurate reflection of a company’s value, leading to better capital allocation and a more efficient market overall.
Example: Convertible bond arbitrage
An example of short sellers using convertible bond arbitrage involves purchasing convertible bonds while simultaneously short selling the underlying stock.
Convertible bonds are hybrid securities that can be converted into a predetermined number of the company’s shares at specific times and prices.
When a short seller identifies a pricing inefficiency in the convertible bond relative to the underlying stock, they can exploit this discrepancy for profit.
Here’s a simplified example:
- A trader/investor notices that a convertible bond is undervalued compared to the underlying stock.
- They purchase the convertible bond, which gives them the right to convert it into a specific number of shares at a later date.
- Simultaneously, they short sell the underlying stock, borrowing shares to sell them in the market with the expectation of buying them back at a lower price.
- If the stock price declines, the investor can profit from the short position by buying back the shares at a lower price and returning them to the lender.
- If the stock price increases, the investor can exercise the conversion option on the convertible bond, obtaining the shares at the predetermined conversion price, which is lower than the current market price. They can then use these shares to close out the short position.
In this way, convertible bond arbitrage allows short sellers to profit from pricing inefficiencies while also providing a hedge against potential losses.
17) Trading Spot/Forward Pricing in FX Markets
Shorting is important in FX markets when traders play the spot/forward pricing dynamic.
We’ll explain this a bit below.
There’s an important connection between:
- a) the difference in interest rates and
- b) the relationship between spot and forward currency prices
For a country experiencing debt or financial problems, in particular, the expected decline in a currency’s value is factored into the forward price being lower than the spot price.
For instance, if the market anticipates a 5% drop in a currency’s value over a year, it would require a 5% higher interest rate for that currency to offset that move.
The situation becomes more extreme when depreciation is expected over shorter periods.
If a 5% depreciation is expected within a month, the currency would need a 5% higher monthly interest rate – equivalent to an annual interest rate of around 80% (the compounding of 5% per month over a year) – which could cause a severe economic contraction in an already struggling economy.
Due to this, a small expected currency depreciation (e.g., 5-10% annually) resulting in a large interest rate premium (e.g., 5-10% higher per year) is unacceptable.
In other words, managing a currency’s decline while reserves are dropping leads the market to expect ongoing currency depreciation. This pushes domestic interest rates higher, tightening monetary policy when the economy is already weak.
Additionally, the expectation of continuous devaluation spurs increased capital outflows and devaluation speculation, widening the balance of payments gap and forcing the central bank to use more reserves to defend the currency (or abandon the planned gradual depreciation).
Eventually, a currency defense through spending reserves must stop because no sensible policymaker wants to deplete these savings.
Typically, in such currency defenses, policymakers – particularly those defending a currency peg – make confident statements promising to prevent the currency from weakening.
These events typically occur just before the cycle moves to the next stage – allowing the currency to devalue.
During a currency defense, it’s common to see the forward currency price fall before the spot price. (This opens up opportunities for traders.)
This results from the relationship between the interest rate differential and the spot/forward currency pricing mentioned earlier.
When a country tightens monetary policy to support the currency, it increases the interest rate differential to artificially maintain the spot price.
While this supports the spot, the forward continues to decline relative to it.
The forward leads the spot downward as the interest rate differential increases.
The spot then catches up after the currency is let go, and the decrease in the spot exchange rate allows the interest differential to narrow, which mechanically causes the forward to rally relative to the spot.
Traders executing the long/short strategy associated with this process are simply following the mechanics of it.
18) Greenshoe Option in IPOs
The Greenshoe option is a vital form of short selling in the initial public offering (IPO) process, as it helps stabilize the stock price and manage potential volatility.
In a separate article, we had the hypothetical case of XYZ Corp, the underwriters have the option to issue an extra 150,000 shares (15% of the original offering), resulting in an over-allotment of 1,150,000 shares.
This leads to a short position on the additional shares, essentially borrowing them from the company, with proceeds held in escrow.
The Greenshoe option’s primary purpose is stabilization.
After the shares are listed and begin trading, the underwriters observe the stock’s performance.
If the stock price rises, they cover their short position by buying the extra 150,000 shares in the open market using the escrowed funds.
These transactions increase demand, stabilizing the stock price and preventing sudden price drops that could harm the company and investors.
In short, the Greenshoe option is crucial in managing stock price fluctuations during an IPO.
By creating a short position on additional shares, underwriters can facilitate stock price stabilization, ensuring a smoother transition to public trading and ultimately protecting both the issuing company and investors.
How Short Selling Works
FAQs – Why Short Selling Is Important in Financial Markets
What is short selling in the stock market?
Short selling also allows investors and traders to borrow shares of a company’s stock or other financial instrument so that they can sell them on the open market.
This type of borrowing is typically done when an investor believes that the value of the security will decrease in the near future and they want to profit from it.
After selling the borrowed shares, they can then buy them back at a lower price and return them to their lender at a profit.
Is short selling bad?
On one hand, short selling can be used to hedge against market volatility and manage financial risk.
Some consider it a form of “market manipulation” or even an illegal practice if done without proper authorization.
Since it is possible to make quick profits through short selling, some investors may use this strategy in a way that could be considered unethical.
For example, they might spread rumors about a company that would lead to its share price dropping, then profit from the resulting decrease in value.
However, this is why securities laws exist and are important.
Short sellers, like those who are long a stock, cannot trade on, or induce others to trade on, information they know to be false.
At the same time, it is important to understand that all trading comes with risks and careful consideration should always be taken before taking any action in the market – regardless of whether it is being long or short selling.
It is up to individual investors to decide for themselves if they are comfortable with the risks associated with short selling and whether it is the best strategy for their portfolio.
It should also be noted that regulatory authorities closely monitor the market to ensure that no illegal activities take place, so any suspicious trades will be investigated if necessary.
Short selling can be a legitimate tool used by experienced investors, but it should always be utilized in a way that respects all applicable laws and regulations as well as ethical principles.
Doing so ensures that everyone has an equal opportunity to make trading decisions based on thorough research and analysis and not through questionable tactics.
Why is it called short selling?
Short selling is a trading strategy in which an investor sells securities they do not currently own, with the expectation that the security’s price will decrease.
This allows them to purchase the same security at a lower price later and make a profit on the difference. It is called “short selling” because it involves taking a “short position” on the market – in other words, betting that prices will go down instead of up.
Sometimes investors also refer to this tactic as “shorting” or “going short”.
Regardless of the name, it is important to understand that there are risks associated with any investment strategy – including short selling. Therefore, it should only be used by experienced investors who are comfortable with these risks and have a clear plan for their investments.
For those who choose to pursue short selling, it is important to stay informed of the latest regulations and industry best practices regarding this type of transaction. Doing so can help ensure that your strategy remains legal and ethical while also avoiding costly mistakes.
What are the advantages of short selling?
Short selling can help investors diversify their portfolios and manage risk more effectively.
It also provides a way to take advantage of market downturns, as traders may be able to profit from price declines that they would otherwise not benefit from if they were only investing long.
It also allows traders to express bearish opinions on particular stocks or markets without having to hold a large amount of capital in order to do so.
It can help various entities manage risks by holding returns streams that gain in value when something falls in price.
Finally, it helps bring equilibrium back into financial markets by allowing investors to bet against overvalued securities, which may help prevent bubbles from forming.
Who benefits from short selling?
Short selling can benefit both the investor, who profits from the transaction, and the financial markets as a whole by providing increased liquidity and price discovery.
The investor benefits since they are able to make a profit off of their short position if the security’s price decreases.
This also provides them with an opportunity to hedge against market volatility and manage their portfolio risk.
Those who sell commodities often hedge their risks by shorting the commodity they own to lock in prices for an anticipated future sale.
At the same time, this type of trading helps increase liquidity in the markets by allowing investors to easily trade securities that may not be actively traded by providing buyers with more options.
Additionally, it helps uncover potential mispricing which in turn leads to improved price discovery – meaning that everyone has access to more accurate information about pricing trends on different assets.
As a result, short selling can be a beneficial tool for investors and the market as a whole.
Conclusion – Why Short Selling Is Important in Financial Markets
Short selling is an important part of healthy financial markets. It allows investors and traders to mitigate risk, borrow shares, engage in basis and relative value trades, increase price discovery, increase liquidity, and diversify portfolios.
Additionally it provides a source of returns during down markets and can exploit market inefficiencies. Ultimately these benefits lead to more efficient financial markets and improved returns for investors.
However, short selling should only be used by experienced and knowledgeable traders, investors, and market participants who understand the purposes and risks associated with this strategy. It is important to familiarize yourself with regulations and industry best practices when engaging in any type of trading activity.