Hal Varian on Short Selling

This is from March 10, 2005:

Five Years After Nasdaq Hit Its Peak, Some Lessons Learned, by Hal Varian, NY Times: On  March 10, 2000, five years ago today, the Nasdaq composite index hit its high, 5,132.52, at the peak of the dot-com bubble. It is fitting to commemorate this anniversary with a column about what financial economists have learned from this episode.

Perhaps the most fundamental question one can ask about the bubble is how it could have happened in the first place. How could stock prices be pushed up to such irrational and unsustainable levels?

Few economists would deny that fools and gamblers participate in the stock market. But the participation of such irrational traders does not necessarily imply that stock prices themselves should be irrational.

In principle, irrational exuberance should be self-correcting. If overly optimistic investors bid up the price of a stock, rational investors should step in and sell shares, moving the price back down to a realistic level.

This adjustment process does not even require that sellers own shares of the overpriced stock. Someone who thinks that the price of a stock will fall but does not own any shares can borrow shares to sell, a practice known as selling short.

If an investor sells short and the stock price does indeed fall, he can buy shares to pay back the loan and pocket the difference as profit. As with other sorts of borrowing, the borrower typically has to pay interest on the loan.

But, in the case of the Internet boom, short selling was apparently not strong enough to damp the stock price increases during the Internet bubble. The question is, Why not?

Owen A. Lamont, a professor of finance at the Yale School of Management, reviews some recent work in the economics of short selling in the latest issue of the NBER Reporter (available at www.nber.org).

As he points out, there were striking examples of apparent overpricing of stocks in 2000. For example, in March of that year, 3Com sold a fraction of its holding of Palm; it announced that by the end of the year it would disburse the rest of its holdings by giving 3Com shareholders 1.5 shares of Palm for each share of 3Com they owned.

One would expect that 3Com shares would be worth at least 1.5 times the value of Palm shares. But on the first day of trading after the announcement, Palm shares were worth $95.06 a share while 3Com shares fell to $81.81. The market was valuing the non-Palm part of 3Com's business at minus $63.

This pricing anomaly was widely reported in the financial press. The most likely explanation was that day traders and other overly optimistic investors bid up the price of Palm stock to excessive levels. These traders were presumably unaware that they could acquire Palm indirectly by buying 3Com stock.

The apparent mispricing created a low-risk arbitrage opportunity. A savvy investor could buy some 3Com shares outright, borrow some Palm shares, sell them, and repay the borrowed Palm stock in a few months when 3Com issued the Palm shares.

Indeed, many investors did exactly that. At one point, the number of Palm shares borrowed to sell short was 147 percent of the shares outstanding. (The number could exceed 100 percent since shares could be borrowed only to be lent out again.)

Even this additional supply of shares was not enough to quell the Palm enthusiasts. According to Professor Lamont and his co-author on one paper, Richard H. Thaler, a big part of the problem is that the market for borrowing shares is not a centralized market with quoted prices, but rather a highly disaggregated market.

In many cases, it was quite difficult to find shares of Palm that could be sold - and when they could be found, the interest rate charged to borrow them was quite high.

Short selling was not the only way to bet against Palm. One could also buy put options, which allowed the stock to be sold for a fixed price. But the options were also mispriced during this period, making such investments unattractive.

So the anomaly persisted for many months. Eventually, of course, it disappeared: a few weeks before 3Com issued its remaining Palm shares, the prices reflected the appropriate ratio. But the short selling constraints seemingly allowed the mispricing to persist for an awfully long time.

Many intelligent investors believe that short selling is a strong signal of subsequent price declines. Professor Lamont's work and that of several other academics find that this is so: stocks that are subject to large short selling tend to have lower subsequent returns.

One might ask why short selling is not immediately reflected in the price of a stock. The reason appears to be related to the basic problem with short selling: there is no centralized market for borrowing stock, so it can take time to find shares to sell short. Typically, there is no problem in finding shares of large companies that are traded frequently. But shares of small companies, whose stock is lightly traded, may be hard to find.

This finding suggests that the total amount of short selling might be a good predictor of stock market movements in general. Somewhat surprisingly, this turns out not to be true. In fact, during the bubble years, the aggregate amount of short selling declined as stock prices were bid up. As Professor Lamont and his co-author on another paper, Jeremy C. Stein, remark, "Short selling does not play a particularly helpful role in stabilizing the overall stock market."

But again one must ask why not. One suggested answer is that short selling arbitrage has more risk than appears at first glance. For example, the owner of the shares can force the borrower to return them under certain conditions. Hence, the short seller might find his position unwound at an inconvenient time. This risk factor means that short sellers may want to take smaller positions than they would otherwise prefer.

It appears that at least on some occasions, short selling constraints can disrupt the normal operation of supply and demand: when supply is constrained, stock prices end up being determined by those who are overly optimistic.

Comments

[Patrick]

"One might ask why short selling is not immediately reflected in the price of a stock. The reason appears to be related to the basic problem with short selling: there is no centralized market for borrowing stock, so it can take time to find shares to sell short."

There is no market because the owners of the stock would insist on being paid for the use of their property. Check your margin agreements. Brokers can lend out your shares bought on margin and keep the proceeds without paying you for the use of your property. Anyone who ever received a surprise 1099 for payment in lieu of dividends has been a victim of this scam.

[Patrick]

Just to belabour the point: the SEC blanket ban on short selling financials was the wrong thing to do. All they had to do was enforce the law against naked short selling.

Patrick Byrne - who until recently was often called a nut - has been sounding the alarming on naked short selling for a long time. Seems he might have been right all along.

http://www.forbes.com/2008/09/23/naked-shorting-trades-oped-cx_pb_0923byrne.html

http://www.deepcapture.com/washington-mutual-price-versus-failures-to-deliver/

[ddt]

I think that the author is missing the main reason that short selling is more risky: the losses are unlimited, and the upside is limited. When going long the loss is limited, but the upside is unlimited, so in most situations short selling is unattractive.

If you buy a stock at $10, all you can lose is that $10
If that stock goes to $100 you make $90

If you short a stock at $10 and then it goes up to a hundred dollars your loss is $90
If you short the stock at $10 and it goes to $0 you only make $10.

you can't expect short-sellers to reign in a bubble, because they are exposing themselves to a huge amount of risk for limited upside. It only really makes sense to short a stock when you are certain that a company is going to take a huge hit, after doing a lot of research. I think that that is why it's such a strong indicator - the people shorting have to make damn sure that they are right, and that a lower price is imminent. If you think there is a bubble you want to hold off shorting until it is about to collapse, because as they say "the markets can stay irrational for longer than you can stay solvent". You will get wiped out quicker shorting into a bubble than buying into a bear market.

[Patrick]

ddt

Yes, in theory loses on short positions are infinite but in practice the investor faces margin call which puts a floor under loses.

I suppose broker dealers or maybe big hedge funds might not face this, but that's the exception rather than the rule.

[hari]

Hedge Funds and Investment Banks have cannibalized short selling and specially *naked* shorting of stocks in financial sector.

In Oct 1987, the amount of short selling and (naked) options were exuberant and we all lost our portfolios within a Fri collapse.

There must be a regulatory mechanism to control naked options by demanding evidence of the underlying stock purchase. Otherwise, as I know, Merrill was making tons of money by seeing what the clients were actually doing on the screen....

[Tom W]

Short selling doesn't adjust prices for the reason Keynes identified years ago: "the market can remain irrational longer than you can remain solvent."

If you're selling short, it's not enough for you to be right about some stock being overvalued. You must know when the bubble will pop. Otherwise, you might start shorting tech companies in 1997, and you would lose your shirt over the next 3 years, forcing you into insolvency.

An overvalued asset can become much more overvalued. The overvaluation can last for years. Who knows when a bubble will end; bubbles can perpetuate themselves for a long time.

In the mean time, you are forced into heavier losses by your short positions until you are forced to liquidate those positions by your broker since shorting requires a margin account.

Shorting isn't worth the risk during the middle of a bubble.

[Roy Zimmerhansl]

ddt
I think you need to expand your example a little bit to put it in a more accurate market context.
When you short a stock at $20.00 the maximum profit is $20.00.
If a stock has been beaten down and goes to $2.00, the amount of "professional" shorting tends to decrease because the profit potential is $2.00.
At this stage, the likelihood of loss resulting from an outside influence - takeover or GOVERNMENT BAILOUT - increases and so the risk/reward scenario changes.
Put another way, it is more likely that the stock will go RAPIDLY from $2 to $4 than it from $20 to $40.

http://securitieslending.typepad.com

[anne]

http://www.nytimes.com/2005/03/10/business/10scene.html

March 10, 2005

Five Years After Nasdaq Hit Its Peak, Some Lessons Learned
By HAL R. VARIAN

[Working link.]

[Lafayette]

Gambling casino

Article: As Professor Lamont and his co-author on another paper, Jeremy C. Stein, remark, "Short selling does not play a particularly helpful role in stabilizing the overall stock market."

I should be relieved to read that.

However, I would have liked to see an argument as to why short-selling is beneficial, in any respect, to the markets proper functioning. Not in terms of generating profit, but in the functionality of the market mechanism.

Gambling, it would seem to me, is a matter for Las Vegas casinos. And, were they to do so, they would not allow hallucinatory borrowing to fund a bet. The Casinos have a uniquely effective way of handling bum debtors ... they ended up buried somewhere in the Nevada desert.

Is it right therefore to confuse Wall Street with a Gambling Casino?

[a]

"Short selling was not the only way to bet against Palm. One could also buy put options, which allowed the stock to be sold for a fixed price. But the options were also mispriced during this period, making such investments unattractive."

I think "mispriced" may be incorrect. One parameter determining the price of an equity option is the rate at which one can borrow stock. If the cost of borrowing stock goes up, the offer price on a put option goes up. This is "mispricing" only to those who think borrowing stocks should be free.

IMHO the reason why there are equity bubbles, even where it is possible to short sell the stock, is that a stock price in the short- and even short-medium-term is based on supply and demand, and less on fundamentals. While it's pretty easy to recognize a bubble, it's far less easy to know when the peak of a bubble will occur. So while it may be sure that shorting today may eventually earn money, that "eventual" may find the trader losing so much money on his trade as the stock continues to go up, that he can't keep the position and needs to buy back the stock. It's just too risky; there are easier ways to make money, so why bother?

[bakho]

What DDT said. Short selling depends on market timing. Bubble exuberance is difficult to predict. Short selling is only low risk when the signs are saying collapse.

Roy has risk about right for a stock with a stable price. However, he is missing the "opportunity cost". In a stock bubble. People know it will eventually crash. However, being on the sidelines means missing a large opportunity.

Another part that is not addressed is 401 and pension investors that are buying into stock funds (some of them index funds) that may be REQUIRED to purchase stock at bubble prices. This is especially true if an S&P 500 stock has a bubble price. S$P index funds MUST purchase that stock.

[The Trend Is Your Friend]

Short selling can't stop bubbles because short sellers lose money when prices are going up. Short sellers best strategy is to get out of the way when the trend is up. Short selling can bring bubbles back to earth faster when the trend turns. Short sellers make money when prices are going down, so their best strategy when the trend is down is to pile on.

[Trend Follower]

Any Flying Dutchman who shorted tulip bulbs near the top made a killing. Most Dutch investors who bought the tulip bulbs at excessively high prices probably never saw a bubble before, and were probably not experienced investors. Most Flying Dutchmen who made a killing shorting the bulbs probably remembered how the last bubble worked, and invested accordingly, as Friend of the Trend said.

It might be a good idea to interview actual people who actually bought tulip bulbs at extremely high prices, and lost money, to confirm our suspicions about how hope, greed, and fear drive investors decisions.

[Trend Follower]

Lafayette

I also think the similiarities and differences between casinos and Wall Strret are very interesting. Casinos have defined risk for every game, they know exactly how much the house will win on each game, over any period of time, depending on the number of players.

Except sports betting. Handicappers working for casinos set the odds so that the casinos are taking on risk. But the handicappers really know how bettors will bet based on the odds, and handicappers really know the probabilites for how correct their odds are.

Trading and investing is probably more like poker, its a game of skill. Luck plays a big part, but players control their risk, they can fold any time and wait for the next hand if they are unlucky or unskilled. Or they can go all in, and lose it all, or win big.

Not surprisingly, casinos do not risk money on poker games. The house has no edge and no defined risk with poker. Casinos charge a fee for providing a nice poker room.

Risk, money management, probability, the edge, many fundamental concepts are the same for casinos and operators in financial markets.

says...

Lotteries, sports betting, betting on horses at the track, casinos, speculating in financial markets. Why not? Find an edge, strike it rich! Basic human drives at work. Let it be.

[mrrunangun]

If a buyer is investing in a stock, the degree of precision necessary in the timing of the purchase is low. If a buyer is speculating in an option on the same stock, the degree of precision necessary in the timing is high, and higher in proportion to how short the term of the option may be. Long-dated options generally accordingly require a higher premium. Shorting is speculation and while timing precision is not as critical as in a short-dated option it is much more critical than in a long stock purchase. Long-dated puts, if available at a reasonable price, are probably safer than short-selling, as your loss is limited to the premium paid.

[Max Rockbin]

There is a major timing asymmetry in bubbles. They tend to inflate gradually and pop suddenly. For an investor, the holding period of a short (odds are) will be much longer than the holding period for a long on a bubble stock.
People may go in an out of GOOG on a long bet, but a short really has to hang in there for the big plummet. That means fewer investors, institutional or otherwise, will opt to commit to a short.

[cm]

Patrick: A general short-selling ban may be easier to enforce than naked shorting (but I'm not sure). Tactical decisions such as this are often driven by expediency, not technical merit. Defining new "offenses" to "explain" who/what has been at fault for something also probably is supposed to look better than starting to enforce previously abrogated laws.

[wcw]

I could argue with you kids, but you tire me. I do want to note one thing: anyone who tilts against the naked-shorting windmill is an idiot.

FD: I was short FRE starting in December 2006, and I don't care who knows it.

FD2: I used futures.

[Jesse]

Short selling can significantly impact price in short term depending on the amount of selling as compared to the average daily volume, because in the short term prices are set 'at the margin.'

A more familiar example might be a poker game. There are generally betting limits and rules to level the playing field, and to prevent the well-heeled professional players from dominating a table that might be frequented by talented amateurs.

High stakes no limit games only work if there is some parity in capitalization and knowledge amongst the players.

There are examples more numerous to count of pools of stock market operators driving the price of a stock up or down depending on their designs, and sometimes both.

Short selling is a necessary component of market trading, without which many hedge plays do not work. As is most aspects of life, it is not the thing itself that is counter-productive, it is the abuse of it when taken to excess and used with other devices such as planting stories and spreading rumours. It happens much more often than you might think if you are not 'in the markets.'

a related matter:

Gangs of NY

http://tinyurl.com/4p2ohh

[Patrick]

"I could argue with you kids, but you tire me. I do want to note one thing: anyone who tilts against the naked-shorting windmill is an idiot.'

Grow up. This adds nothing to the discussion. If you think so little of the commentors on this blog it's idiotic to spend your time making inane, rude comments. I suggest you try to add something substantive or just move on.

[Lafayette]

TisF: Short sellers make money when prices are going down, so their best strategy when the trend is down is to pile on.

Short selling down, long selling up, what's the difference -- both are gambling often with borrowed money.

Betting on market moves is more in the realm of sports (such as horse racing) than finance. Gambling is a regulated game, so should short-selling. Especially with its power to exacerbate downturns in market equity values.

It has no intrinsic market-functional merit. Methinks.