Despite rancor, short sellers play a helpful role in the stock market

The recent stock market volatility around GameStop, AMC Entertainment and other beaten-down companies has rekindled suspicion, if not downright hostility, toward short sellers.

Corporate executives have long grated at the selling pressure and negative comments that short sellers direct at their corporations. Elon Musk is one prominent critic of institutional investors who have heavily shorted Tesla, and there are other examples.

Trevor Milton, the then-head of zero emissions truck manufacturer Nikola Corp., vowed to “make a collage of all these troll comments/fake articles/lies from shorts.” That post on Twitter came weeks before a highly critical report from short seller Hindenburg Research decimated Nikola’s stock price and led to Milton’s departure from the Phoenixbased company that he founded.

More recently, thousands of small retail traders took up pitchforks and marched, virtually, against the short sellers, too. They temporarily drove up prices in heavily shorted stocks in an effort to “squeeze” the sellers and, somewhat ironically, force them to buy shares in companies they disdained to limit further losses.

Short selling has existed for more than a century and thus predates retirement accounts, mutual funds, exchange-traded options and many other financial tools that we take for granted.

Still, there’s a lot about short selling that does seem unnatural, and even nefarious. Short sellers borrow shares and sell them now at what they hope will be high prices, with the aim of buying for cheap down the road, thereby closing out their positions at a profit. In so doing, they’re often betting against the rest of us.

And if big institutional short sellers must unload other stocks that they like in order to raise cash to close out their short positions — as happened recently with GameStop and others — it can destabilize the broader market.

Short selling brings perspective

With all this in mind, why don’t regulators outlaw short selling? The answer is simple: Because there’s nothing really wrong with it.

For starters, short sales enable you to hedge a portfolio of “long” stock holdings, if you want. There are other ways to hedge, such a buying a “put” option that gains value if the market or certain stocks decline. But short selling can be helpful, too.

More important, short sellers counter the favorable views of stocks held by bullish investors. Their skepticism, even negativity, helps to keep prices at more realistic levels, reflecting a broader sampling of opinions and forecasts.

“If you don’t have people short selling because it’s not allowed, then basically what happens is the only people whose views are reflected in the stock price are people who have a positive view,” said Gerald Dwyer, former director of the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta.

His comments came more than a decade ago, during the Great Recession stock market slump that coincided with a lot of high-profile short selling.

Short sellers have found problems

Short sellers don’t just dislike certain stocks but often make their unfavorable views widely known, helping to counter bullish reports from Wall Street analysts and company executives.

“They definitely have an incentive to talk it down,” said Geoffrey Smith, an associate professor of finance at Arizona State University, who sees broad benefits in the greater pricing information and other feedback that short sellers provide.

The research often is extensive — something lightly followed second- or third-tier companies may otherwise lack.

Hindenburg’s detailed report on Nikola was slanted in places but nevertheless raised important questions such as whether the manufacturer’s cuttingedge trucks could actually run on their own power.

The selling pressure and negative views of short sellers can temper bouts of euphoria and deflate bubbles. This can benefit long investors, too, such as people purchasing stock each pay period through a 401(k) plan, allowing them to buy in at lower prices.

Short sellers who spread rumors in hopes of exploiting a price drop are unsavory and possibly guilty of illegal market manipulation, but you could make the same argument about some bullish investors trying to push a stock higher.

“A lot of the negative connotations associated with short selling are actually related to just selling something you don’t own,” Dwyer said.

Positive outcomes for some firms

Short sellers also can encourage, unwittingly or not, favorable evaluations about companies — and higher prices for their shares.

The recent volatility spike in long-beleaguered retail stocks put them in the headlines again and possibly helped to focus discussions around their “hidden value,” wrote John Berlau, senior fellow at the Competitive Enterprise Institute, in a recent blog.

Plenty of stocks, including Tesla, have flourished over time despite short sellers making them prime targets.

Also, as noted, short sellers must eventually buy shares in the stocks they dislike so they can return the borrowed shares to brokerages and thereby close out their positions. Short sellers are thus a latent source of buying power, and in a squeeze, this can come on quickly.

Berlau, of the limited government-focused Competitive Enterprise Institute, argued against calls to regulate short sellers.

Such proposals seem to pop up regularly after bouts of market turmoil but are unneeded and often politically motivated, he said.

Selling before you buy: It’s legal

Short selling also is open to smaller retail investors, though it’s usually associated with the big, mysterious hedge funds.

A recent alert from the Securities and Exchange Commission noted that the vast majority of short sales are legal, including in some cases the tactic of selling shares before you have borrowed them (known as a “naked” short sale).

That more retail investors don’t engage in short selling reflects the strangeness of investing in reverse (selling before you buy) and the potential for unlimited losses if a stock keeps moving against you.

Given that the market has historically risen dramatically over time, that’s a big risk.