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Finance and capital markets
Course: Finance and capital markets > Unit 6
Lesson 2: Shorting stockIs short selling bad?
A discussion of the virtues and/or vices of short selling. Created by Sal Khan.
Want to join the conversation?
- What happens if you short sell a stock, and then the company goes bankrupt?
If that companies stock disappears for whatever reason, doesn't that mean you effectively aren't obliged to buy a now defunct or 0 value stock for the person you borrowed it from? Would that mean you made a profit from selling an item you never bought or owned at any point?(109 votes)- Doing a quick web search, it seems to be in fact the case that if the company goes bankrupt and the initial stock holders aren't awarded anything (likely), you will never have to buy the stock.
Meaning the end result is that you end up making money selling something you never owned.
How is this meta finance stuff, such as in this case or Credit default swaps when people insure things they don't even own, legal/ethical?(63 votes)
- How does short selling reduce volatility? People who short and long a stock are doing the same thing: Selling High and Buying Low, but just in a different order. If they're both going to sell at a peak and buy at a trough, aren't they just adding to volatility?(4 votes)
- Volatility is caused by having an unbalanced relationship between buyers & sellers. Everyone trying to sell at the same time one day, everyone trying to buy the same stock another day. Having people on the other side of the trade, balances it out, for a more smooth trading pattern.(38 votes)
- Okay so that whole BL;SH, decreases volatility, while BH;SL increases volatility seems a little funny to me. I mean basically it's saying that no matter what the volatility remains the same, right? Because in order to Buy Low and Sell High, someone else must Sell Low and Buy High. IDk I'm just a bit confused by the redundancy. Can someone please help explain this to me?(6 votes)
- You are right, for every buyer there is a seller and vice versa. However it is the amount of buyers vs. the amount of sellers that determines the price. Adding ADDITIONAL buyers or ADDITIONAL sellers when it seems that there is to much on the other side, WILL normalize trading patterns.(14 votes)
- It is interesting to see if the same applies when somebody with an insider information is short selling(7 votes)
- The definition of insider information is subject to enormous variation(4 votes)
- What concerns me most about short-selling is that people can make money from destructive activities (terrorists for example could short company before attacking it, and cover afterwards). Is there any real defense against these perverse incentives?(5 votes)
- There are just as many ways to manipulate a stock up as there is to manipulate a stock down. Anyone remember the popular takeover rumors from an "Anonymous buyer" that were so popular between 2004-2006? Often times a manufactured short squeeze higher is far more violent than a manufactured sell off. But in the end the net result of short selling is beneficial to the market. If you are the CEO of a large corporation, you have access to all sorts of business opportunities. Some may be more legitimate and legal than others. If you know that people will actively try to get rich off of your mistakes, it changes how you make business decisions.
But, Andrew is right about the terrorist thing. There are large lists published by the government with every terrorist and known alias which are distributed to every financial institution. And each institution is required to sign off stating that no one on the list has an account at that institution.(3 votes)
- I would be very curious about some of the market manipulation, and what goes on there.(3 votes)
- I suggest taking a walk through D.C. is you're really that curious, specifically Congress and wherever the lobbyists hang out.(4 votes)
- Then isn't it theoretically possible for a really talented investor/shortseller then, to make money at all times, regardless of if a stock is doing well or not?
For example, let's say an investor could see the future and bought stock at a low price, then sold at a peak. Then they initiate a short sell immediately at the peak and buy back when the stock is low again. They immediately take the money they made from the short sell and buy stock again just before it rises. In essence, they are profiting from a company at all times, even during economic loss.
Now let's assume many people could do this. Wouldn't you basically be generating money where there is none, and therefore causing inflation?
It seems like economic manipulations like this (creating money where there was none before) is what leads to economic collapse/recession.
Of course, that is an extreme example. Banks giving out high risk loans and credit are probably more to blame for creating inflation. But I'm new to economics, so maybe I'm completely wrong(3 votes)- Thanks- the Zero sum point makes sense now that I realize the person buying from the successful short seller immediately loses THEIR money on the investment. I had forgotten to take that into consideration. Seems so obvious in retrospect!(3 votes)
- Is there any empirical research that I can look at and that back these statements regarding the incentives of short sellers and other market operators to disclose info on stocks or are they just the result of common sense reasoning?(5 votes)
- It's common sense, but I'd like to see any studies that have been conducted. It's hard to think of how you would conduct such a study. As Sal points out in the video, nearly the entire investing world (and people outside of the investing world as well) are on the positive side. Hard to get a basis of comparison in terms of what constitutes someone pumping/not being critical of a stock when the whole world is oriented that way. Could be a little tricky in terms of methodology... but would like to see if anyone has sources?(0 votes)
- It is interesting to see again at the end of this in January 2021.
Would Khan Academy be able to make a video about the current market situation as related to the GameStop stock, Hedge Funds, and WallStreetBets Subreddit?(3 votes) - Would it be illegal to spread (demonstrably false) rumours about a company, in order to bring down its stock value (as part of a shorting attempt)? If so, how else can someone effectively short? Sal mentioned using formulas, or 'reading market psychology' - can anyone be more specific?(2 votes)
- Yes, that is market manipulation and it is illegal, so when you want to do it - which hedge fund managers do all the time, just Google Bill Ackman - you make sure it is impossible to tell that the information you are spreading is obviously false. That's easy to do.(2 votes)
Video transcript
I think we know enough about
shorting now that we can start thinking about whether it's a
good or bad thing to have in financial markets. And what I've done here is
I've drawn a hypothetical stock chart for a company. This time right here. This is the price
of the company. And let's just say that this is
a chart in a universe that doesn't have short
sellers in it. So this is all-- here a lot of
people are buying the stock, then over here some people,
maybe they get freaked out or whatever, they start selling. And then more people buy. So demands a little higher
than supply, so the price goes up. And that just generally
drives the volatility. Now in a short selling world,
what would happen? Let's let's think about two
scenarios, a short seller who makes money, and a short
seller who loses money. So a short seller
making money. What would a short seller making
money have to do if this is the stock chart. Obviously, they don't see the
stock chart beyond the day that they're actually making
the trade, but in order to make money they'll actually--
they'll have to short at the local peaks. And they would have to
cover their shorts at the local minimum. So a good short seller-- or
you can even say a perfect short seller would maybe short
here-- let me make it a different color so you can see
where he's acting-- would short here and then
cover there. And he would make that much
money on that move. And then he would wait a little
bit, wait for the stock to get expensive again
in his mind. And he would short here, and
then he would cover here. This would kind of be--
obviously it's very unlikely that someone could so well pick
tops and bottoms. But let's say they're just really
good at their analysis and figuring out market psychology
and things like that. And they would just
keep doing it. They would short here
and cover here. What would that actually
do to the stock? The green line was a
reality where you had no short sellers. Now if all of a sudden you
allowed short selling, and they had these guys come into
the market who know how to make money shorting. He's shorting up here. So what would shorting do? Shorting is you're borrowing
the stock and selling it. So he's creating extra supply
for the stock, right? So what he would be doing at
this point, by shorting, is he would actually be lowering
the price at this point. So let me draw the curve. So if there's a bunch of short
sellers acting in this range, it would actually
lower the peak. Because you have a bunch--
you have some more aggregate sellers. So the price wouldn't
go as high. And then on the other hand,
these short sellers have to cover right here, right? They're going to cover
their position. So at the low point you have
more aggregate buyers covering a short position, is just you're
buying the stock to pay it back, because you borrowed
it earlier. So here you would have more
aggregate buyers. And then at this point, once
again you have more aggregate sellers, so the price
won't go as high. You have more aggregate buyers
here, because the short sellers need to cover, so the
price won't go as low. And so forth and so on. And the bottom line is, a short
seller who's making money on the stock market, so
they're shorting the stock at peaks and covering the stock
at troughs, is actually reducing the volatility
of the stock. And that's good for everybody. That's good for the company's
management. That's good for the actual
shareholders of the company. And obviously it's good for the
short sellers because they are actually making money. And this is actually true for
anyone making money in the stock market. That they're reducing
volatility. What is a long-- just a regular
investor-- or I guess you could call them a trader
since they're buying and selling-- a regular trader would
make money by buying here and selling here. So really a regular trader
is not any different. A regular long trader is no
different than a short seller, it's just the order in which
they're buying or selling. But anyone making money is
buying at low points and selling at high points. And anyone doing that is
helping to reduce the volatility in the stock. And even if you're a long term
buy and hold player, you would rather sit and hold a stock--
you would rather be a holder of a stock that does this,
than a holder of a stock that does this. Now there are a lot of players
both on-- you could call them traders because they're buying
and selling on a regular basis-- that aren't kind
of doing this. Maybe they're piling on the
shorts at a low point and they're causing the stock
to go down even more. And then, when the stock starts
to move up they get scared and they buy it, and
it causes the stock to move up even more. And it increases the volatility
of the stock. But these guys are being
penalized because they're losing money. The people who sell at low
points and then buy at high points, and increase
the volatility, they're getting killed. They're falling every day. So it's not like you
have to create some penalty for those guys. Their penalty is that
they're just bad traders, they're bad investors. And they're just going
to lose their shirts. So if you're assuming that none
of these traders in any way manipulating the markets
or spreading false rumors. Anyone making money on a stock,
as long as they're not manipulating it, on either the
short or the long side, is actually a net asset
for the stock. That they're actually reducing
the volatility of the stock price. I guess another thing to think
about and this is just from a-- it's good. They're reducing the volatility,
so from that point sorting doesn't seem too
bad, for me, or in general to the market. But another way to think about
it is, kind of where are all the incentives in the markets? Who has an incentive to be
positive on a stock? And who has an incentive to
be a negative on a stock? Or to scrutinize a stocks? Well, the biggest, I guess
cheerleaders, for a stock, and it depends on their degree of
kind of credibility or ethics, would be the company's
management, right? These are people-- it would
be company's management. These are people who obviously
run the company, but they have the best transparency into the
financials of a company, and they tend to be shareholders
of the company or get compensated based on
how the stock does. So these guys have every
incentive to be positive. And, as we've seen multiple
examples of, whether you're talking about the investment
banks, or Enron, or Accenture, they'll often kind of hide the
truth when things get bad. So these guys are definitely big
time positive on stocks. Then, let's see, who are the
other players or the influencers on financial
markets? Well, a big one is the
financial press. And I'll write it out here so we
can have a discussion about whether they are pumpers of
stock or whether they tend to be more-- whether they tend
to scrutinize things a little bit more. An important thing to think
about with the financial press, and next time you watch
CNBC-- and I don't want to just pick on them-- is how
do they make money? Do they make money by
finding things that are wrong with companies? Do they make money by
making you money? No, they make money
by selling ads. And then the next question,
obviously, is who are they selling ads to? Are they selling ads for mops? Are they selling ads
for bicycles? No, they're selling ads to
financial services companies. So people who want to manage
your wealth, stock brokers, mutual fund companies, anyone
who can advertise. And this is key, too, because--
I don't know, you're probably not aware of it but
hedge funds can't advertise, so they're not consumers of the
financial-- or they're not customers of the financial
press. The only people who are
customers of the financial press are money managers,
financial planners, and things like that-- brokers,
mutual funds. And all of these guys benefit
when stock markets go up. Obviously mutual fund managers
will-- they tend to be long only, so they only want
things to go up. Stock brokers-- you might say,
oh you know, a stock broker can advise you to go long or
short and they just care about how many transactions
you make. But in general, more and more
people put money into the stock market in rising
markets. In a market like you're seeing
right now over the last year, people are pulling out-- you
could say oh, maybe people aren't doing more transactions,
but the general net effect is, people
are pulling money out of the markets. So when they're pulling money
out of the markets, brokers are getting less transactions,
they're managing less money. And that's also true of
the money managers. And there's also just another
ancillary side effect, is when markets go down and people
become less excited about the stock market, people stop
watching CNBC and CNNfn. And so even those few ads that
are for mops and for bicycles and for cars will get
fewer viewers. So in general the financial
press, at least in my opinion, is squarely in this camp. And then we can talk more, you
know, sell side analysts. You've probably heard the term
sell side and buy side. But sell side analysts are the
analysts that work for the major brokerages and investment
banks, who publish those reports that you see in
those ratings, a buy rating on IBM, or whatever. And the reason why they call
them sell side analysts is because they work for the people
who are essentially, on some level, selling-- you could
either view them as they often offer securities, or they
offer financial services to, often the companies
themselves, or to potential acquirers of the companies. Or they're selling their
services-- I mean, usually-- they're brokerage services, so
they're trying to get people to transact, they're actually
brokers on some level. But clearly these guys, their
incentive, since their customer tends to be the
management of companies, is to be very, very, very positive. And you should say oh, there
are other people who, their whole job is to scrutinize
these people. Like, the government. But if you think about it once
again, the government likes a rising stock market. It takes-- when people's 401k's
are rising, the economy does better, the government
doesn't have to worry as much about other types of social
benefits, and unemployment, and things like that. So in general, and if you want
to be more, I guess, if you want to be more critical of the
government, you could also say that they are, to some
degree, very close to the management of these firms and
to financial companies. And to some degree, these guys
have significant clout in terms of lobbyists-- and, well
actually, I would even say the bankers, too. They have significant clout in
terms of lobbying, and just access to government,
generally. And government drives the
regulators, so these guys are also on the positive camp. And then finally you have
the ratings agencies. And the ratings agencies mainly operate in the debt world. And we'll talk more
about that. But, if you can scrutinize a
company on the debt level, and you say oh wow, this company
really isn't that good, they're not going to be
able pay off its debt. That kills the stock. But once again you have to
realize that the rating agencies are also paid by the
bankers, so the rating agencies are also-- have the
incentive to kind of not see things when things are bad. So out of everyone in the
financial services, or the financial world, that we've
talked about right now, they all benefit when stocks
continue to go up. Even when they go up beyond what
they really should go up. And even if they all kind of
know that things are a little bit too expensive. Or this management team might
be a little shady, or they might be covering
up something. None of these people
really have an incentive to expose it. And the only people who do
are the short sellers. These are the only people who
really have, arguably the sophistication and the time and
the monetary incentive to really look and scrutinize
what management is doing. To really look in the books
and kind of put a puzzle together, or put a bunch of
pieces together to come to the conclusion, wait, the numbers
that management is spouting really don't add up. And because of x, y and z,
this company really is overvalued. So to a large degree they are
kind of on society's side in preventing management from kind
of being overly bullish. And I don't want to sound like
someone who just broadly is defending short sellers. There is a class of short
sellers that I think would be bad, and that's the people who
are spreading false rumors, and being market manipulators. So there's just the
general market manipulation, or rumor mongering. And that definitely is bad, and
to some degree, if you can show someone is doing that,
there should be some type of penalty for doing it. But even there, and just it in
my experience participating in public markets, if I had to
pick-- if I had to pick between the left side of that
chart, between this side of this charge and this side of
this chart-- and if I had to say who does spread
false information when it does get spread? I think often times management
is a little bit more guilty of it than the short sellers. In fact there's very few times
that I've seen where the short sellers are-- there's some
negative thesis on the stock and where it really comes out
to be completely untrue. Although, there are examples,
and those short sellers, I don't think are really in the
mainstream Anyway, I don't want to meander too much. I realize that this video
has already gotten long. But I thought it's a nice,
useful discussion to maybe think a little bit about whether
short selling really is all that bad, even if you
are a long investor.