Why Short Selling Doesn’t Affect the Market
I’m tired of hearing that short sales are killing stocks. Naked short selling hurts stocks, but real short selling actually has a net economic benefit. We need to reign in on what used to be illegal, but the practice of short selling does have true economic merit.
In a free market the price is tethered to supply and demand. When people demand more of something, supply must increase or price must increase. In the stock market, supply should never increase. Naked short selling increases supply artificially, and that’s why it’s illegal and its also why the law short be enforced.
But when there is no naked short selling, the process of short selling is a simple contract. You agree to rent me shares, I sell them and agree to buy the same shares back for you later. Simple business transaction!
Short selling speculators help even the line between the market’s equilibrium price and the trading price. You see when there is only upward pressure in the market, stocks soar to unprecedented levels far too quickly. Insert bubbles here.
The below image is what happens in a rallying market, with little short interest from speculators.
The continued buying of bubbles and other extended rallies creates a premium, that is, a positive difference between the equilibrium of supply and demand.
When short selling is put back into the market, the short interest reduces the premium between current price (CP) and equilibrium (EQ). Smoothing the price and creating greater liquidity, both are positive events for the buy and hold investor.
Here’s another model, considering naked short selling:
Too much short interest creates a scenario where more stock is available for sale than actually exists. Its quantitative easing, dilution, whatever you want to call it.
When a naked short goes to cover itself though, it creates a position where phantom shares have to be removed from the system. Thus an instantaneous shortage of shares causes the market to spring upward. Each short covered is a share off the market, prices go up.
There it is, very simple and all diagrammed with the help of MS Paint.
sorry for sounding ignorant but how does naked shortselling artifically increase the supply of shares?
When I short stock for speculative purposes, the stock is borrowed from another owner, and this stock cannot be borrowed twice over….All naked short selling creates is a larger contingent of sellers on the mkt
Short selling should be a +1/-1 activity. One share borrowed, one sold.
However, naked short selling is not selling borrowed stock. You’re naked, you don’t have the stock to sell short.
So what happens is +1(phantom shares)/-1 short.