Short selling is important to a variety of market participants. Investors use short positions to express a view that a security, such as a stock, is overvalued or to hedge against risk. Pension funds, mutual funds, and endowments earn returns by lending stocks to short sellers, and market makers facilitate the buying and selling of stocks. Short selling is a big part of the market, accounting for nearly 50 percent of the volume of trading in listed equity shares. Short selling is employed widely. It contributes to overall market quality, dampens volatility, and promotes fraud detection and capital formation.
Remitop’s short selling white paper provides an in-depth look at the practice, explaining what it is and how, through appropriate regulation, it leads to healthier markets.
Price efficiency is a measure of how accurately market prices reflect available information. A stock’s price is deemed to be efficient if it accurately reflects market participants’ collective opinion of its fundamental value. An efficient price would reflect both optimistic and pessimistic investor opinions. At the end of the day, short selling allows stock prices to be more accurate.
Markets are more stable when there is ample liquidity. Liquidity is
the ability of trades to occur in reasonably large amounts at or
near the market price. Short selling supplies liquidity and reduces
volatility when short sellers trade in the opposite direction of
price movements. It is a widely held misconception that short
selling increases market volatility during times of extreme market
stress, leading to accelerated declines in prices.
In fact, the
SEC finds shows that during a price decline, short sellers will
often sell less, or close out their short positions by purchasing
shares of the security, which offsets sales by long position
holders. Short selling further promotes market stability and
transparency by providing valuable indicators of risky, volatile, or
overvalued stocks.
From a long-term perspective, stocks that are overvalued present a problem for the economy. The market will eventually correct the mispricing, but in the meantime, real resources may flow to the overvalued stock or industry. Perhaps the best example was the housing bubble that popped in 2008. Short selling indicated the housing market was overvalued and prevented the systemic shock caused by the 2008 crash from being even more widespread. However, the practiced faced widespread backlash and the SEC instituted a temporary ban on short selling. Research published by the New York Federal Reserve found the ban failed to stop free falling price shares and reduced market liquidity.