How Short-Selling Reduces Volatility
Bank shares in Dublin have shot up today after the Financial Regulator introduced a ban on shorting them. The obvious interpretation is that short-sellers are now unwinding their positions and that traditional investors believe it is safer to return to the market.
While this price action is easily explicable, in the medium and long term the ban is unlikely to help the banks. Why? Because short-selling actually reduces market volatility. Let me explain how.
Suppose shares in Bank A are trading at €10 each. Suppose I take a look at their loan book and figure that the share price would be much closer to zero if it was being valued properly. So, for a small fee, I borrow some Bank A shares and sell them. This puts marginal downward pressure on the stock. If enough people do it with me and we run down the price, it might even upset some of the bank’s executives, long-term shareholders, employees and customers.
What happens next? I wait to see if my view of the correct share price (<€10) becomes more widespread. If this happens then I get to buy back shares at some reduced price, say €1 each, and then return them to the lender. I gain €9 per share minus the cost of borrowing the shares and transaction costs.
If the share price rises, however, then I get drowned and face an unlimited loss.
The key fact here is that when I eventually buy back the shares I put upward pressure on the stock price. Just as my original selling of the shares dragged it downwards, my later action pushed it upwards. My profit is proportional to the intertemporal mispricing which I help to correct, and the social function I provide is to supply shares when demand for them is high, and a buyer when demand for them is low.
It might help to consider what would have happened if I had not acted. There would have been fewer sellers when Bank A was at €10 so the price would stay higher for longer. Assuming that sentiment eventually does turn against the bank, then when it reaches €1 there is one fewer buyer to lift it back up, so it falls even harder. Without me, the swing is from €10 to €1 is actually more wild.
This explains how short-sellers contribute to market efficiency by smoothing out stock price movements and thus removing volatility from the system.
There is an argument sometimes made that short-sellers can act in packs to collectively drive down stock prices. It is alleged that false rumours are spread which also help to intimidate normal shareholders. A downward trend is manipulated into existence, after which the short-sellers then cover their positions and take their unfair profits.
While this practice is theoretically possible, it would be extremely difficult for short-sellers to coordinate such activity. Also, the profits could not very be great unless a significant number of ordinary shareholders were scared away from their holdings. But in any case it is true that investors surrender to short-term trends and the rumour mill both when stocks rise and fall, so these issues, to the extent that they exist, are not unique to the shorts.
In terms of what is happening right now, it seems most likely that the bans on short selling the Irish, UK and US financials have been precipitated by a combination of political factors. These include the need for some to assign blame for recent disastrous share price declines, and the general trend for increased regulations and restrictions on trading activities.
The bans are understood to be temporary so it is to be hoped that they can be reversed as quickly as possible to restore one of the increasingly few forces for order in the financial markets.