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What is short selling?

This is an edited transcript of the talk first delivered to the Options21 Market Briefing on the 31st of August, 2008.

I've been asked a number of times:  "What is short selling?", so I'm going to answer that here. 

Imagine my colleague Paul is fortunate enough to be in possession of 10 large boxes of beer, freely available from our local liquor store.  Imagine also that I enjoy parties, and in an impulsive fit of haste I suddenly decide to throw a party tonight.  Not having much time to organise things, I look across the office at my colleague Paul and ask politely if I could borrow his ten boxes of beer.

Paul agrees.  I promise to return his beer within a month, and I take his beer home with me to prepare for my big party.  Paul owns the beer, but for now at least it is in my possession.  Because I don't have enough time to get organised properly, hardly anyone turns up.  The party is a failure.  I no longer need Paul's beer.

But of those guests who do turn up, someone asks if they could buy my beer.  They offer quite a good price.  I agree to sell all the beer to the guest, I take the money, and I hand over possession of the beer.  The guest takes delivery.  There is a small issue in that it wasn't really my beer.  Later that week I buy an identical type and quantity of beer, and I return all the beer to Paul.

Paul doesn't actually get back exactly his beer.  It is a substitute, but he is unable to detect any difference.  It is precisely the same brand, in precisely the same packaging, and of precisely the same quantity.  There is no difference between the borrowed beer and the returned beer except, maybe, if there are any little serial number markings on the sides of the bottles, the serial numbers won’t match.  But who worries about serial numbers when it comes to beer?  Paul assures me that he doesn't mind that the beer is a substitute beer because it is the same brand, and Paul is happy and thankful that I've returned the same quantity.

Now we could ask a moral question:  have I done anything wrong?  I've sold something which I did not own, but I've made good.  Is that moral or immoral?  There is more to morality than merely deciding whether anyone suffered a loss or got hurt, but that’s the subject of a separate philosophical discussion.

My beer sale is one type of short selling.  It is called covered short selling, because I had possession of the beer, I was able to deliver the beer to the buyer, and I fully intended to deliver the beer after taking the money, because I always deal “straight” and honestly.

What would happen if I placed large newspaper and television advertisements offering millions of cartons of beer for sale at a massively discounted price?  People would buy less beer from their traditional liquor stores, they would defer their purchases in anticipation of lower prices, and the price of beer would fall.

But what would happen if I neither owned nor had possession of any beer, and did not intend to deliver any beer for any sale?  I could for a short time influence the beer price by leading people to the false belief that huge quantities of beer are about to be unleashed onto the beer market at a great discount.

If there really was no beer available for sale the advertisements would have been false.  People would soon discover that a huge warehouse full of cheap beer did not exist.  The price of beer would rise again as people returned to their normal liquor stores.  The beer price would have been temporarily distorted, through manipulation of perception and the creation of a false belief.  Would I have done anything immoral?

Now imagine that Paul also owns a significant number of shares in Google, the US internet stock.  What would happen if I borrowed 100 of those shares from Paul, and sold them into the market?  Let’s say I sold the borrowed Google shares.  The stock market operates on T+3, which means I have three days in which to deliver those shares after selling them.  I have every intent to deliver those shares to the buyer, and indeed I do deliver them.  I also have an obligation to give them back to Paul within one month.

Two weeks after I sold them, I could buy 100 Google shares back from the market, and subsequently give them back to Paul.  They are probably not exactly same shares, but that doesn't matter.  Like the beer, Paul does not care that the share certificates have different serial numbers.  All that matters is that Paul has been returned the same type and quantity of shares.  He is grateful to have his portfolio restored with the return of his shares.  I might even offer Paul a small amount of money to compensate him for renting or leasing his shares to me.  Would I have done anything immoral in borrowing and selling Paul’s shares?

This type of transaction is also termed covered short selling because the shares I offered for sale were “covered” by the shares in my possession, even though I was not the legal owner of them.  I had the owner's consent to sell them.  I was able to deliver the shares to the buyer, I intended to deliver, and indeed I did deliver and make good the sale.

It is legal to short sell shares on the Australian and US markets, as long as the seller has possession of the shares and intends to deliver them to the buyer.  Often a broker will hold title to many clients’ shares. 

Brokers are able to lend those shares to other clients if they agree to return them.  In that way those other clients can short sell shares.  Short selling is very risky.  It is possible for short sellers to lose a lot of money if the shares have to be bought back at a subsequently high price in order make good the loan and to return the shares to the broker and the rightful owner.  Indeed, short selling exposes the seller to potentially unlimited risk.  We strongly recommend never to short sell shares without some form of hedging or protection.

Some people short sell because they might determine that a company is badly managed and foresee a fall in value.  They can exploit that forecast for profit simply by short selling the stock and buying back the stock later at a lower price.  Short sellers often identify badly managed companies early, and perform a useful function by exposing bad practice and bringing to the early attention of the market useful negative information which might otherwise be concealed for a longer time.  Obviously covered short sellers would only target poor quality companies.  They wouldn't short sell without a sound reason to believe that the price would be likely to fall.  They might have more information, or they might have a sharper perception of the true state of the target company.  The threat of short sellers helps keep businesses disciplined.  Without short sellers, imprudent, stupid and bad practice within a company can be hidden and perpetuated more easily, sometimes at the expense of the shareholders.

Legal covered short selling can hasten and temporarily amplify a fall in the share price.  But legal covered short selling can not sustain a fall in the share price because ultimately the shares must be returned their owner.  Buying the shares back from the market tends to push the price up.

Some superannuation funds and other fund managers hold large amounts of stock which represents the investment funds entrusted to them by their clients.  Some of those funds lend, lease or rent those shares to short sellers, knowing it may well drive the price down.  Is that appropriate or moral for fund managers to do?

Google is a large company, and my sale earlier of 100 shares could not affect the share price.  But let’s now consider a very small company, maybe like a small gold mining or exploration stock which does not have many shares on issue, for example 50 million shares or so.  What would happen if I placed an order to sell 20 million shares, "at market"?  What if I neither owned nor had possession of any shares I offered for sale?  What would happen to the share price?  It would fall.  That type of short selling is called naked short selling.  It's naked because the sale is not covered by my possession of the actual stock.  Would that be immoral?  Does anyone suffer?

Naked short selling is illegal, both in Australia and in the US, where we do most of our trading.  It falsely inflates the number of shares available, and unfairly destroys the wealth of the real shareholders.  The share price of any particular stock is due in part to the scarcity of those shares.  There should always be only a fixed number of shares on issue and in circulation at any one time.  Naked short selling brings shares into the market which don't exist.  And because shares are interchangeable and indistinguishable from one another, like bottles of beer, the newly sold shares dilute the value of all the shares.  Naked short selling creates the perception that there are more shares in existence than there really should be.  That is why naked short selling is illegal.  It falsely and unfairly pushes down the share price.  The share price no longer reflects real supply and demand, or the scarcity, because the false short sales interfere with the number of shares available to the market.

If shares are sold, and those shares not delivered within the prescribed T+3 time limit, red lights and alarms are signalled to the exchange regulators.  Even though it is illegal, sometimes, some people do try to distort the market price by offering stock for sale which they neither possess nor intend to deliver.  They might want to drive down a company's share price to acquire the assets at below cost.

In mid-2008 the US Securities and Exchange Commission made the curious announcement that it would temporarily no longer tolerate illegal naked short selling on 19 selected financial stocks.  The implications are bizarre.

Options are very different from shares.  Shares are issued by a company to those investors who provide equity.  Although those shares are identical and interchangeable so that they can be freely traded, the number on issue is always strictly limited because each share represents a fixed share of the company.  It is the fixed limit on the number of shares which creates the scarcity which supports the value and price of those shares.  The shares can exist in perpetuity, and are only created or destroyed in an orderly manner to reflect capital adjustments.  Only the company can issue shares.  No one else can create shares in that company.  If anybody other than the issuing company attempted to create a share certificate that would be fraud.

Beer is different.  Beer can be consumed.  In fact lots of beer can be consumed.  It also can be manufactured easily in vast quantities.  Scarcity is not really a factor in determining the price of beer.  In the case of Paul's beer, I wasn't concerned that the buyer would consume it because I knew more would be manufactured.  The price of beer closely reflects the manufacturing, distribution and taxation costs, at least where it is freely available.  Beer is not really a good long term investment, because unlike shares, there is not normally a strictly limited supply, and it is perishable.

Options can be created out of thin air, as it were, more easily than beer can be created.  And options always have a strictly limited life span.  They perish with time.  Options cease to exist when they are exercised or when they expire.  In effect options are either consumed or wasted, just like beer.

It is more appropriate to liken options to insurance policies than to shares.  Options are a contract between a writer and a taker.  Any participant in an options trading market can be a writer, and write options for those takers willing to pay the premium.  The value in options thus does not lie in their scarcity.  When an option is written the writer is paid a premium to take on risk which the taker seeks to cover, or transfer to the writer.  The writer takes on obligations to deliver or to buy stock at a fixed price on or before a fixed future date.  Options are standardised and indistinguishable from one another (that is for a given stock, strike price and expiry date) and thus can be freely traded, just like shares.  But the inherent value of an option is not related to its scarcity, because there is no limit on the number of options contracts that can be opened.

When a writer writes an option the terminology is sometimes used that the writer is “going short” the options.  The writer is not actually selling anything which is scarce.  Nor is the writer interfering with the free market price of those options.  Therefore going short options is not at all the same as selling short shares.  But the terminology used is similar.

There are two ways in which options can be written.  Options can be written “naked”;  or options can be written “covered”.

Whenever writing options the writer should always first ensure he or she is in a position to fulfil the delivery obligations under all circumstances, regardless of what might happen, in case the taker or holder of the option exercises the option. 

Writing covered options means the risk taken on by the writer is already covered in some form, or hedged, or insured.  For example writing a covered call means the writer already owns the underlying stock which the writer might be obliged to sell if the call option is exercised.  Moreover, the holder of an option may decide to sell that already existing option into the market, which would simply be a plain sale.

Writing naked options means the options are written without any protection, thus exposing the writer to potentially unlimited risk.  Writing naked options would be similar to an insurer writing an insurance policy without setting any limit on the maximum amount agreed to be paid out.  We strongly recommend never to write naked options because of the unlimited risk it would expose the writer to.  However to write naked options would neither be immoral nor interfere with the fair operation of the market.

So in summary, we’ve now defined two types of short selling, and for both stocks and for options.

Covered short selling of shares means the seller possesses the shares and intends to make good the delivery of those shares for sale.  Covered short selling of shares is legal.

Naked short selling of shares means the seller does not possess the shares to be sold, and therefore can not deliver them without acquiring them from some other source.  Naked short selling of shares is illegal.

Covered short selling of options, or covered writing of options, means the writer has hedged the exposure to risk.  Naked short selling of options means the writer is writing options without any protection against the risk taken on, so the writer is exposing himself or herself to seriously large downside risk.  Both styles of options writing is legal.


Copyright © 2008 Nils Marchant.

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