Let’s start with a hypothetical bank share belonging to a Spanish Bank called Santander*, that is currently trading at €4.23 a share.
Now ordinarily (ie. in a world without short-selling), I have some limited options:
- If I think that the share price will go up to, say, €5.23 – then I go and buy the share at its current price.
WhenIf it reaches €5.23, I sell it and make a euro profit.
- If I think that the share price will stay the same, I remain ambivalent about buying. Unless every single other stock is collapsing around it – in which case, I might buy it just to preserve my €4.23 of value.
- If I think that the share price will go down to €3.23 – then I just wouldn’t buy the share.
So that’s a world without short-selling. But the story is missing a key variable: investor time horizon.
We can’t just talk about “expectations of the share price”. We have to say when we expect those expectations as well.
The Fourth Dimension of Time
If I take a long-term view on the stock (or industry that the stock is in) – then I won’t be interested in the short-term movements of the share price. I’ll buy the share based on my expectation of an overall increase of the share price over time. Therefore, there’ll be no trading of it to take advantage of short-term profit. This strategy is normally used by large institutions (like pension funds) that have long-term liabilities (so they match the investment time horizon to their liabilities).
If I take a short-term view on the stock – then I only want to trade in it for a few days/weeks, make my profit, and get out. If I think that the price is going to go down, then what I’d really like to do is borrow the share for a bit…
There is room for a little bit of win-win on both sides.
How to Sell Short
I want to take a short-term bet on the share price going down. I reckon it’s going to happen in the next couple of weeks. Santander: currently at €4.23, expecting it to go to €3.23 by Friday.
- I approach an institutional investor (through a broker) and ask to borrow the share until Friday (in exchange for a fee of €0.05). Because they didn’t plan to do anything other than hold the share this week, they agree.
- I take the borrowed share, sell it for €4.23, and put the money in a bank account.
- On Friday, let’s say that the share has actually gone down to €3.23.
- I take €3.23 from the bank account, buy back the share, and take the share plus €0.05 (borrowing fee) back to the institutional investor.
My bank account now has €0.95 (€4.23 – €3.23 – €0.05) that it didn’t have before. Also, the longterm investor has just boosted its return by €0.05 – that it wouldn’t have had otherwise because it wouldn’t have been taking a short-term view.
Except for the schmuck that bought the share at €4.23. But then again – that could be a long-term investor taking a long-term view. Or, maybe I’m just lucky not to be the schmuck today – after all, if the share price had gone up, I would still have had to go buy back the share at market price…
The danger here: if EVERY short-term investor decides to short the share by borrowing it from a long-term investor – then the market will suddenly be flooded with shares being sold.
Excess of supply plus no real demand for buying (all the short-term guys are selling) equals sudden plunge in the share price. Which becomes a little self-fulfilling – and all the short-term guys win! After all, we were betting on the price going down. And now it has.
In fact, were I unscrupulous – I could even manufacture the episode by spreading the short-selling word around…
And the market is thrown into complete disarray, because the giant sell-off makes for some heavy short-term fluctuations – which can spark contagions and people getting called to testify in front of Congress and stuff.
Hence why, when the market is particularly vulnerable, the legislators may just close the tap on short-selling.
Like they’re currently doing in Spain and Italy.
*By “hypothetical” what I mean is “may soon become hypothetical”.