How Short Selling Works

A lot of people and pundits have been blaming short-selling for the recent stock market plummets, and even the SEC temporary banned it at one point recently. But what is short selling? Marketplace’s Patty Hirsch is back with another video and his whiteboard to give you the low-down.



Getting naked in short selling
[Marketplace]

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  1. laserjobs says:

    Short selling does not drive stock prices down it puts a floor in the price. Shooting the shorts out of the water is very profitable plus the SEC will never investigate you since you are making the share prices go up.

    • humphrmi says:

      @laserjobs: dang, we’re two for two, laserjobs!

      I’ve always said: A long position may not buy more stock ever again, but a short seller must be a future buyer.

  2. Anonymous says:

    I’ve seen less and less ‘short selling’ on ebay since the weather turned cold; mostly pants selling now.

  3. HIV 2 Elway says:

    If only we would have shorted some oil futures…

    • Trai_Dep says:

      @HIV 2 Elway Resurrected: Yeah, I recall with wry amusement several posters saying a couple weeks ago, BUY GOLD/COMMODITIES NOW – EVERYTHING ELSE IS JUST FIAT P-A-P-E-R!!
      I’d be great to get a recap from these people, describing how their portfolios look (of course they were shouting the loudest right when the peak hit).
      Except I’m fearful their keyboards would short-circuit from the downpour resulting from their torrents of bitter, recriminating tears.
      rEVOLution, baybie. Revolution!

  4. zarex42 says:

    Nothing wrong with short selling at all, nor is there anything wrong with so-called “naked” short selling, as many people complain. It’s just as legit as buying a stock hoping the price goes up.

    • zibby says:

      @zarex42: Naked short selling is not the same as short selling or buying a stock, and it plays hell with settlements – just to name one issue.

    • leoeris says:

      @zarex42: said the fox to the hens.

    • doodaddy says:

      @zarex42: I haven’t watched the video yet but I hope it points out that short selling DOES drive the price down, just like “long” buying raises the price.

      “Naked” short selling means you don’t even borrow a share to go short that share. So an unscrupulous, large buyer can keep shorting a stock until the price is driven to almost 0, which has bad affects on a company, including failure.

  5. full.tang.halo says:

    nothing wrong with “naked” shorting, cept, ya know, it’s and SEC violation…other than that it’s totally cool, if you dont mind breaking the law.

    But then again if the SEC isn’t enforcing the rules like a bunch of 8 year olds with a sub teacher everything can go to hell pretty quickly.

    • zarex42 says:

      @full.tang.halo:

      The SEC is very misguided when declaring “naked shorting” illegal (if they really do). It’s just as legitimate morally and financially as any short-selling (or any buying, for that matter).

      • zibby says:

        @zarex42: Nonsense again, unless by equating the three you attempt to make some sort of point that all transactions in capital markets are equally evil. Then yeah, I get the wordplay. Cute.

        Otherwise, you make the argument that selling something you are unable to deliver is legit. It ain’t.

      • Snarkysnake says:

        @zarex42:

        “It’s just as legitimate morally and financially as any short-selling”

        Huh ? No it’s not. Naked short selling creates stock that doesn’t exist to be sold by a seller that has no ownership position in the company. This is the kind of financial hocus-pocus that got us in the hot water we are in today. It should be illegal. It’s like gambling with imaginary money in a casino where everyone else pays cash. The moral hazard is terrifying.

        On the other hand,short selling shares that you own and possess is perfectly legit and should be applauded. (Smart short sellers smoked out the crooks at Enron,Global Crossing ,Worldcom and other shady companies). At least you are gambling with your own money and if you are wrong,the pain will be intense.

        Equating naked short selling to investing is like equating buying a lottery ticket to responsible money management.

    • joe714 says:

      @full.tang.halo: Naked short selling is fraud. You’re selling something you don’t own. It’s as legitimate morally as counterfeiting money.

      • zarex42 says:

        @joe714:

        Completely untrue. Selling things you don’t own is universal in business. Brokers, home builders, manufacturers do this all the time. As long as you deliver the goods as specified in the contract, it’s 100% legitimate in business – and as it should be in naked shorting, as well.

        (Of course, if you *can’t* deliver, there should be – and are – financial consequences. But that’s no different than any other business.)

        • zibby says:

          @zarex42: Please. People short naked because they can’t get a locate on a stock, much less an affirmative determination – that is, there is no stock to borrow on the street to deliver to the buyer. It’s not like selling a house that you intend to build; you’re selling something that you know you don’t have and you know have very little chance of getting in three days. In other words, you enter into the contract with – at best – no idea how you will hold up your end, and – at worst – no intention of doing so. Further, the buyer rarely has any way of knowing this in advance and cannot factor this information into his or her decision.

          Summary: Your statements indicate that you completely self-serving or have no idea what you are talking about.

  6. Echomatrix says:

    great video. Makes me wonder how the SEC lets this crap happen…

  7. IrvCrapper says:

    The reduced volume of stories has been pretty evident over the past few days. I have fewer reasons to visit. The stories are less snarky than they’ve been in the past.

    Sadness.

    • Trai_Dep says:

      @IrvCrapper: Yeah, Ben. Please put a smiley face on all future stories dealing with 100-year-storms of the global financial apocalypse!

      Although, I do miss the kittehz.
      Sniff.
      Buy Captain Duvel Moneycat a dish of Perfect Oatmeal, on me? Film at 11:00?

    • West Coast Secessionist says:

      @IrvCrapper: Seriously. It seems like the story volume has dropped by about 75%. WTF, were Chris and Carey doing 75% of the work? Maybe it was they who should have been kept on staff!

    • GavinEstecado says:

      @IrvCrapper:

      Now that you mention it, half the business day is over and there’s only 3 posts. That is sad. I guess it means I’ll have to do more work while at work….

    • m4ximusprim3 says:

      @IrvCrapper: I think it’s just fine, by the way.

      Although I do miss tax cat. Dearly.

      I love you, tax cat. I love you.

  8. AtomicPlayboy says:

    @Ben Popken: I really like this sort of layman’s description of a common, but poorly understood, financial practice. More of this type of thing, please.

  9. chrisjames says:

    Could someone clarify the last half a minute or so of what he’s saying? Why does naked short selling drag down share prices, and why doesn’t clothed short selling drag it down? Is it because Caitlin doesn’t get to invest her $500 in FCOJ, although really it’s being invested in SEAN? I mean, assuming she planned on it in the first place, which is probably true in these situations. That muddies it up for me even more.

    I get that it all seems sneaky, short selling, because no, one person is not going to be pleased in any situation. That’s Caitlin, after learning that if she waited three days she could have spent half as much. No matter if she’s long or short, that sort of news hurts. I get that naked short selling should be illegal, because you’re trading what you don’t have. That has no-no written all over it. I don’t get how that has such a supposedly big impact on price, though.

    • WriterJudd says:

      @chrisjames: short selling does indeed impose a temporary downward pressure on stock price, but when done legally, the effect is limited by: (a. a finite number of “shortable” shares, and (b. the risk inherent to shorting (which is the possibility of incurring infinite losses as the stock increases toward infinity).
      Naked shorting is a problem because it breaks this equilibrium, as the the supply of shortable shares becomes theoretically infinite, thereby applying such strong downward pressure on price as to eliminate the risk (to the perpetrator) described in “b”.
      Zooming out a bit, it becomes apparent that this destroys efficient markets, which are supposed to be the best means of price discovery based on all investors having access to the same, accurate information at the same time. Imagine a market in which something as basic as the supply of a thing (keeping in mind price lies at the intersection of supply and demand) is unknown to the marketplace. Thanks to naked shorting, for years the actual supply of stock in hundreds of small companies has been a mystery to all but a few criminals.

  10. swicklund says:

    There is an unspoken issue here. If “Kate” wanted 100 shares of FCOJ and had to buy them on the open market, she would drive up that stock price, as she is bidding against other buyers.
    When you short naked, you do not have to acquire the shares at all on the day you “sell” to Kate. Thus you are sapping demand from the market, and if you do this enough – you service all or most of the demand through uncovered shorts – you force real sellers to drop their price to stir up demand. Thus you create a self-fulfilling decline…

    • Trai_Dep says:

      @swicklund: That’s a brilliant observation. Well done!

    • gibbersome says:

      @swicklund:
      Thanks, I was wondering why naked short selling hurt the price of the stock. It’s supply and demand, naked short selling is a way to decrease demand by (what seems to be) fraud.

      But wouldn’t Kate just buy the shares after 3 days when John cannot sell them. Won’t she be happy that she can now get the shares at a lower price (when FCOJ drops to $5)?

    • ZukeZuke says:

      @swicklund: Brilliant explanation, thanks! I didn’t understand that last part either, about why naked short selling drives down the price all by itself.

  11. Jabronimus says:

    I love this guy. I wish I had a better grasp on the economy, but this guy always clears stuff up for me.

  12. Murph1908 says:

    Lewis and Billy Ray knew about short selling. Now that you have learned how it works, the end of that movie should make more sense to you.

    • zlionsfan says:

      @Murph1908: Exactly. I have no idea how many times I saw that movie before I completely understood what happened at the end.

    • squablow says:

      @Murph1908: HA! I was wondering when someone would bring that up. I’m surprised the guy didn’t use their names. “If the Dukes buy as many shares as they can before the weather report comes out….”

      Great video though, certainly cleared up some questions I had.

      • Murph1908 says:

        @zlion

        I did not understand this scene until I learned about short selling either.

        To clarify for others…

        The Dukes, based on their bogus crop report, began buying up shares of FCOJ. They expected the price to jump due to a poor orange crop, and end higher than what they were buying at.

        Other traders, seeing the influential Dukes making a move, joined in and started buying up the OJ too.

        Demand being high, the price began to rise even before the crop report.

        Lewis and Billy Ray, who owned no OJ, began selling it. They were selling short. By selling before they owned, they knew that they would need to buy at the end of the day as much as they sold. They were working with the knowledge that the orange crop was fine.

        Lewis and Billy Ray were selling at the inflated prices that the Dukes spawned with their move.

        The price kept going up and up.

        The Dukes saw them, realized they’d been had, and tried to stop buying, but it was too late.

        The secretary of agriculture delivered the crop report. The orange harvest was fine.

        The traders who had bought the OJ high were now desperate to sell off at as high a price as possible, knowing that the crop report would mean the price would fall. Everyone selling off caused the price to plummet.

        Lewis and Billy Ray began to buy. They were the only buyers, and there were hordes of sellers. The price continued to drop.

        They were not in a hurry to buy. Notice how slowly they are conducting the transactions. They called out the buy just to continue the massive sell off. They wanted to keep the price falling. That way, when margin call came, and they had to buy up to cover what they had sold earlier, the price would be a low as possible.

        When the bell rang, they looked up at the board, saw the low price, and celebrated. They would be buying at that price the OJ they sold at the inflated price.

        In the end, the Dukes had bought high and sold low, and it sent them to live on the streets.

        Lewis and Billy Ray short sold high, and then bought low, and it sent them to live in paradise.

  13. Trai_Dep says:

    Two things:
    #1: Love these. Informative and fun.

    #2: Short selling has built-in constraints on traders getting in too deep, and they’re transparent to third parties. They’re self-policing, in other words.
    Naked short selling lacks these features and they’re be difficult to regulate since there are only two parties involved. Traders, in over their heads, could easily justify doubling down to stay afloat until carnage inevitably results. Structurally, they’re a train wreck waiting to happen. Keep ‘em banned.

  14. rtac5b says:

    Short selling is used to hedge as well. Preventing short selling breaks assumptions in the Black-Scholes option pricing model as well as all sorts of things.

  15. coren says:

    I think it’s Paddy not Patty.

    So, I’ve seen and sort of understand now, how the process works. How are people suggesting this is causing the market to plummet?

    • m4ximusprim3 says:

      @coren: Because everyone shorting at once involves lots of selling, based on the premise of buying back later at a lower price.

      If everyone sells, the price of the stock goes down. It becomes a self fufilling prophecy. Thus companies are “dragged down” by massive shorting.

  16. Trai_Dep says:

    …Although if not naked, everyone can see there’s an imbalance, who’s liable for how much, too many parties sign too many contracts to hide bad bets (which they have to pay off quickly) and these short-sells require collateral in one form or or another.
    The reason why there are fewer short-sellers than long is that one wrong bet can liquidate years of profits, so it polices itself.
    They provide an important function: if the only thing you can do is buy in a market, inflated values become the norm, until the inevitable calamity. Short-sellers provide a fire-break against irrational exuberance, signaling caution.

  17. MikeHerbst says:

    This is all great except for one thing: FCOJ trades as a commodity future, not stock. I know because my finance guys Winthorpe and Valentine told me so.

    [en.wikipedia.org]

  18. dmuth says:

    I found it amusing that he mentioned FCOJ and short selling. Since short selling FCOJ was a major plot point in the movie Trading Places.

  19. Anonymous says:

    I think there is a flaw in his logic. Short-selling in and of itself does not cause the stock to drop precipitously. It’s the fact that the SEC did not enforce the 3-day rule where your are required to locate the shares you are borrowing. So short sellers could just sell and not cover (nor locate shares to borrow) for an indefinite period.

    If the 3-day rule is enforced, then the short sellers MUST cover some way. If they can’t find shares to borrow, then they have to buy them on the open market.

    And if there are too many short-sellers buying the stock trying to cover (high demand), we have a classic short squeeze where the price spikes.

    The key to remember is that short sellers MUST cover their positions at some point either at a gain or a loss. Every short position means a buy of that same stock is an eventuality.

  20. fredmertz says:

    If a stock’s fundamentals should make it go higher, there is nothing short sellers can do in the mid/long term to make it go down. Stocks go where the numbers dictate, not the short sellers or big long holders. That’s not to say that people spreading rumors can’t move the stock wildly in the short-term — but longs can do that as well. When they banned short selling in financial stocks, they did nothing but go down, partly because there were fewer people left to cover the stocks as they went down because they were afraid they’d never be able to short them again.

  21. Oryx says:

    Not to mention short sellers can help alert investors to companies who are cooking the books, etc. As has been stated, they perform a necessary function in the market. People are just lazy and short sellers are easy scapegoats.

  22. jiminator says:

    I don’t think the naked short selling description is useful at all. The issue with short selling is that it puts a glut of cheap stock on the market and it has the effect of diluting the value of common stock. Some of the banks were dragged down because of the total shares up to 1/3 were “created” by short selling. If someone takes any strong company and “creates” 50% new stock and sells it they can easily dilute the value of the company. They would have to have deep pockets, but a lot of the hedge funds do. If the short selling starts to gain momentum on a stock that will create profits which allows for further short selling. I suspect many of the hedge funds helped ride our economy into virtual bankruptcy. While naked shorting makes it easier to “create” stock and causes problems when defaults occur, overall it is not the issue.

  23. Bammer4 says:

    Re: NSS video lesson.
    How sweet and innocent that looks.

    Now make Sam a hedge fund instead of a retail investor.

    FCOG only has 1,000,000 shares issued.

    Sam The Hedge Fund sells Caitlyn 100,000 shares naked for $10.

    The storm moves north and FCOJ goes to $15.

    Sam The Hedge Fund dumps 500,000 shares into the market naked at prices from $15 driving the supply curve to the right and driving the price down to $5.

    Now Sam The Hedge Fund is happy and everyone else is unhappy, including the 50 other investors who are holding fake shares and being told by their broker that they are real.

    Sam The Hedge Fund is not finished.

    Sam The Hedge Fund now pulls out all the stops. he dumps another 5,000,000 shares into the market naked driving the price of FCOJ down to sub penny.

    FCOJ is now in default on a number of its loan obligations due to stock price and files bankruptcy. The court invalidates the common stock, wiping out all the shareholders completely, and turns the company over to the creditors.

    Sam The Hedge Fund keeps the tens of millions he just made on all those naked shares he sold. Sam The Hedge Fund does not pay taxes on his profits because there was never a transaction closing his position.

    The SEC protects Sam The Hedge Fund in these transactions by keeping all of his trades and naked shorts secret saying that disclosure would release proprietary trading secrets to the public.

    Sam The Hedge Fund wins big. Everybody else loses.

  24. Bammer4 says:

    Another way to look at that naked short transaction…..

    Caitlyn fully believes, and has been told by her broker, that she bought and paid for shares of FCOJ stock. Her monthly statement and her confirmations will show that she owns the shares that she paid for.

    What Caitlyn actually bought was an undated futures contract for delivery of her shares at some unspecified date in the future, maybe, if ever.

    The question is. Would Caitlyn have paid the same for that undated futures contract, if she had known what it actually was, instead of being fraudulently misled into believing she was purchasing real shares?