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Short Selling

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If you want to understand the bare bones of “going short” in the stock market, read How Porsche hacked the financial system and made a killing by Ivan Krstić.

What is the morality behind going short versus going long?

Investing in shares, or “Going Long”,  is a no brainer – its a force that allows further wealth to be created, rewarding those who see value early, and generally punishing those who forgo making rational judgements. Based on my simplistic understanding below, I’d say “Going Short” is likewise a powerful tool for good – a force that stops wealth from being destroyed – by rewarding those who grab it before it burns up forever. Sure, there may be misuse, especially given the artificial layers of intrigue inherent in a mixed economy. But in principle, shorting is quite heroic!

What is Shorting a stock?

Shorting is when you borrow (not buy) the stock – and immediately sell it for dollars. Say, for $100,000. Whatever the going market rate at today’s share price.

Now you still owe the stock – you might have 3 months to give it back. But you now have $100,000. You can use it to buy the shares later off the market.

If the share price goes down – then sweet! It now costs you $70,000. So you buy the stock, return it, and keep $30,000 profit for yourself.

But if the share price climbs and climbs over the next 3 months, you’re screwed. Let’s say it now costs $120,000 to buy those shares. You have to use your $100,000 plus another $20,000 to buy those shares from the market. Suddenly you’re negative $120,000!

The Morality of Shorting

In principle, in an ideal capitalist system, and from the point of view of an investor rather than a speculator, going short on a stock is as morally sound as going long. In both cases, the more rational choice gets rewarded. And in both cases money tends to flow from those of lesser integrity to those with greater integrity.

Going Long is your attempt to profit in your judgement that a company is on the way up. This is your evaluation. Perhaps you have calculated the stock to be under-valued, or you believe the idea, the brand and/or people in the company to be stronger than others think. If you buy the stock and it goes up, your assessment has been confirmed, your rationality rewarded. Those who sold early loose out – they weren’t rational enough to see the value you saw. You profit, the Company profits, the Seller misses an opportunity. The good strengthens the good.

Going Short is your attempt to profit from your judgement that a stock is over-valued and on the way down. Perhaps you calculate the company’s assets as overpriced and its liabilities unacknowledged, or you judge the owners to be thieves, or the business idea a fad about to run out of steam. If the stock indeed falls, you profit and your judgement has been rewarded. Those that purchased the stock you sold are punished. You profit, the buyer loses, the Company loses, and the Lender of the stock looses  (for they get their stock back at a value lower than when they lent it you). Money flows from the bad to the good.

Warren Buffet is the star representative of going long – and of integrity being rewarded. There is no self deception with this guy! Just down to earth rationality and a clean, joyful conscience. And the money he makes then gets put back into other companies he deems worthy.

The stars of going short are generally deemed suspect, as morally grey. But this is a mixed economy; both rogues and angels can make it. So lets consider a moral case; Jim Chanos judged Enron a fraud while Wall-Street salivated over easy fortunes. He shorted Enron and made a fortune. Sure, he told the press before buying back. But his good judgement was rewarded at the expense of the herd who were properly punished for their self deception. And by calling it early he played his part in taking down a bad company. I hate to think, if short selling had not been invented, how many more years could have Enron sustained its hoax?

Ideally, you want a system that possesses the tools that enable and reward its people to both seek and grow the good companies – and seek and destroy the bad companies.

You might think – what’s wrong with plain buying and selling to determine the share price? Doesn’t a simple sell off achieve the same result? Not at all. When a stock tumbles, value is simply destroyed for everybody. Shorting allows, instead, for value to be transferred. A market therefor needs de-investors – just as much as it needs investors. The latter is a force for wealth creation. The former is a force against wealth destruction.

Imagine one society without Short Selling: people start pouring their fortunes into a company. The company starts burning up the invested cash for fuel to keep the CEO’s office warm. At the end of the year, the CEO announces, shivering, that the company is bust. People are holding worthless shares, and a chunk of GDP has been destroyed forever.

Now imagine a society with Short Sellers. They watch the CEO carefully, as he rolls some of that investment cash into a cigar. The CEO strikes a match, and the Short Sellers are off and running to borrow all the stock they can, which they sell immediately to the irrationally greedy people pouring their fortunes into the company. The Short Sellers tell the press that the CEO is an idiot and that the speculators are all fools. Some speculators don’t care, some scream blue murder, fearful that the Shorts are going to de-rail their gravy train, others listen and get out – but ultimately the CEO brings down and destroys the company. Instead of value being destroyed, it has been transferred to the Short Seller.  The Value, the money, still exists – in the Short Seller’s bank account. Society is much better off. Not only has wealth been preserved, and a bad company bought to its knees earlier than it might have been, but a nice measure of justice has been metered out, transferring wealth from people who were less inclined to do their due diligence to those who were more so inclined.

Short Sellers, in an ideal system, are its natural financial cops; they actively ferret out bad stock early to make a profit – and save value from permanent destruction as a happy consequence. And they have to do it under pressure of much larger risks, and a much sterner demand on their independence and integrity. Its heroic.

In principle!


Written by xavierseton

May 7, 2009 at 7:14 pm

Posted in Economics

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