Irish Liberty Forum

How Short-Selling Reduces Volatility

with 6 comments

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.

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Written by Graham

September 19, 2008 at 3:49 pm

Posted in economics, finance

6 Responses

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  1. Thanks for explaining that to me Murray!!

    retrolives

    September 19, 2008 at 11:07 pm

  2. Hey Graham,

    Thanks for the explanation. Short-sellers last came
    under fire during the oil price surge, despite the
    fact that shorted stocks (of oil or shares) account
    for less than 10% of those traded (though this is a
    difficult figure to measure). However, I think there
    are some issues that you didn’t adequately cover.

    The world’s financial system is in an irrational crisis
    at the moment: banks and investors are too scared to
    lend to one-another. The governments and their regulators are left in a tricky situation, and have to be seen to be taking decisive action; hence the banning of short-selling. Whether the short-sellers are responsible for the downturn or not, and I’m pretty sure they’re not, is irrelevant. The job of the governments is to restore confidence and see us through this short-term difficulty, and this ban is an effective way to do so.

    As for reducing volatility, I think you made a mistake
    in not accounting for when the short-seller was wrong. The reduction you talk about is due to the upward pressure the short-seller puts on the stock when he buys it back, and this is a marginal decrease in volatility. If the stock was actually worth €10 or more, the short-seller would unnecessarily put upward and then downward pressure on the stock. This marginal increase in volatility is twice the marginal decrease in volatility which occurs when the short-seller is right. For this reason, the short-seller would have to be right at least 2/3 of the time in order to reduce volatility.

    You are right that short-sellers would find it difficult
    to organise to drive down a stock, but they can react
    to rumours and short-term trends a lot faster than a ‘real’ investor. This sort of reactionary trading is very
    dangerous at a time like this, and must be temporarily
    restricted.

    Thanks for the interesting commentary, and keep the blogs coming!

    Howard

    September 20, 2008 at 9:51 am

  3. Short selling can be a useful element of free market economics. Yet I find it hilarious that this website is railing against the temporary banning of this practice in the aftermath of a week where hundreds of billions of tax payers money and the support of the state you decry so much has had to intervene to keep capitalism afloat. Whatever about this post, if your blog is to be taken seriously I’d like to see some comment on the collapse of Lehman Brothers and the nationalisation of Fannie Mae, Freddie Mac and the rest. Captialism may not have collapsed but it neo-liberalism certainly has. Short selling was only banned after the event. It clearly didn’t smooth out the inefficiencies beforehand.

    Interested individual

    September 21, 2008 at 12:40 am

  4. Hey Howard, thanks for commenting, and I hope you’re doing well. You make some great points, by the way. I think I do need some clarifications and would like to express where we differ at the moment. For example, I find it difficult to evaluate the claim that world is in an “irrational” crisis at the moment. I’m trying to figure out the exact logical steps to the argument you provide. As far as I can tell, the idea is that a large number of people (probably mistakenly) blame short-sellers for the problems in the markets, and that the crisis is really about a lack of confidence, and that therefore getting rid of the short-sellers can restore confidence and help to solve the crisis. I hope that is more or less it.

    If that’s what you’re saying, then I should really offer my own explanation of the crisis. I personally don’t believe that low confidence is really the problem. I think low confidence is just an effect of the actual problem, which is that US, UK, Irish and other economies have been decaying for several years thanks to a classic credit-induced business cycle. That wasn’t really the topic of my post, though, so I don’t think I will explain my views on it here in depth. But of course we should examine this question sooner or later.

    I really wanted to make a specific point with respect to volatility, and your point gives me an opportunity to do this in a little more detail. I understand that I could have explained more fully the effects of short-sellers betting wrong, and thanks for pointing that out. The reason I didn’t go into that in more detail is because there is very little pressure to ban short-sellers when they are betting wrong and hence increasing volatility. When markets are rising and short-sellers are routinely crushed, nobody cares about how much volatility they are causing. It’s only in bear markets that shorts get blamed for providing volatility, even though, paradoxically, it is precisely in the bear markets when short-sellers are most productive at removing volatility.

    This is essentially what I’ve noticed: that there is a glaring lack of symmetry in the analysis of shorts vs. buyers. Shorts get blamed for volatility in the bear markets exactly when they are most successfully reducing volatility and when it is actually the buyers of still-overvalued stocks who are making things more volatile. In excessive bull markets, however, buyers never care about the volatility provided by losing short-sellers, perhaps because they are the ones profiting from it. Yet it is the speculative buyers at the top of the bull market who make the crash inevitable.

    Similarly, it is true that short-sellers can react to rumours and short-term trends much quicker than an ordinary investor. Yet these same short-sellers would be rapidly buying up stocks if the rumours and short-term trends were positive. But, since we are experiencing a depression, this is rarely the case and hence the markets plunge ever lower. When news is positive and short-term traders are pushing markets higher and higher, nobody suggests that they should be banned. It is only when news is negative that people want to get rid of them. But the shorts are only the messengers of bad news. For the services they provide to market efficiency, if anything they should be celebrated!

    Graham

    September 21, 2008 at 5:05 am

  5. Hi, Interested Individual. I’m sure you could guess if you’ve been reading this website for long that I would not support any of the bailouts and in fact would have preferred to see many more companies go to the wall already if that is what would have happened without state intervention.

    If you would like to read the commentators with whose analysis of the business cycle I agree, you should check out people like Peter Schiff and Mark Thornton. I can provide you reading materials and references if you like.

    Graham

    September 21, 2008 at 5:18 am

  6. […] How Short-Selling Reduces Volatility […]


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