Why Selling Short is Legal
Many people wonder why selling short is legal. Why is it that some Wall Street guys sell stocks short and make a ton of money off the innocent Independent Investors? Why is selling short allowed at all?
These are excellent questions that deserve correct answers. There are many discussions about selling short but none address the actual reason why selling short is allowed.
Why selling short is legal has to do with supply and demand. Just like any business, companies that offer stock have a finite amount of inventory–shares of their stock. All publicly traded companies have a set amount of outstanding shares that are available to trade among the general public. The total number of outstanding shares of any stock are determined by the company itself and NOT the stock market. When a company goes public, which is when they have their Initial Public Offering IPO debut, they decide how many shares they will offer to the public. These shares are then sold to an underwriter, which is usually an investment bank. It resells the shares first to their preferred customers, and then the rest are offered out to the public on the day the stock IPOs.
Here is a list of the few ways the total number of outstanding shares of stock for a company might change:
1. Stock Split which increases the number of outstanding shares.
2. Reverse Split which decreases the number of outstanding shares.
3. Corporate Buyback where the corporation buys back its own shares of stock.
Most outstanding shares of a company stock are purchased either by giant Mutual and Pension Funds, or a Financial Services Company to build stock derivatives such as Exchange Traded Funds ETFs, Stock Options, or other Stock Derivatives. They can also be bought by a Hedge Fund or the Smaller Funds who manage the Independent Investor money or a family trust. When a Mutual or Pension Fund buys shares of stock, these are placed in LONG TERM accounts and held for the long term. These stocks are not traded every day.
Approximately 75% of all the outstanding shares for all stocks listed on the stock exchanges, for example the NYSE and NASDAQ are held in long term trusts and charters. They are not readily available to buy, which causes an imbalance in Supply and Demand for shares of stock. This imbalance is why selling short is legal and part of the Stock Market. Read More
Supply and Demand
Let’s use an analogy for selling short so that you can clearly get a visual picture.
A hotel has a finite number of rooms, say for example 300 rooms. So that is the total number of rooms the hotel can sell on any given day. As people on vacation or business trips come and go at different times as rooms become available, or sometimes all the rooms are rented so anyone else who wants to rent a room is unable do so.
However other times, a large group of those rooms are reserved with a deposit and guarantee. Those rooms are not available to rent either, as they are reserved for people who are expected to come and stay at the hotel but may not.
If someone really needed to stay at that particular hotel, because there were no other hotels except that one then what would happen? How can someone rent a hotel room if they are all full or reserved?
Theoretically a person who reserved a room could rent out that room to someone who needed it, pocket the money and then pay the hotel for that room the next day even if they themselves did not use it.
When a hotel has too many people who want to rent a room, the price of the room goes up. When the hotel has many vacancies, then the cost of a hotel room goes down.
The person who had reserved the room got a special lower price for that room because they reserved it months ago, but as the price of the hotel rooms rose due to full occupancy, the person could rent out their room to the person who needed the room for a higher price. Since the person who sold his reserved room had purchased it at a lower price, he makes money on the transaction.
Selling Short Maintains Market Liquidity
When the market is running up and up, more and more of the latecomers to the Bull Market decide they want to buy the stock. As they buy the price goes up, because there are fewer Investors and Traders who want to sell the stock. After all, it is going up. Why would anyone want to sell their stock when the price is increasing?
When a speculative market is underway and everyone wants to buy a stock, who will sell the stock? After all, they will lose out on the gains and higher profits.
And therein lies the problem, for which selling short provides a solution. There has to be an incentive for a Market Maker, Hedge Fund, High Frequency Trading HFT firm, or Professional Trader to sell shares of stock when the price is going up. Selling short allows these market liquidity providers with a way to profit from “Making a Market.”
The reason why Selling Short is Legal is to maintain an orderly market, because there must be a SELLER for every BUYER.
If someone wants to buy 100 shares of stock, someone must sell 100 shares to that buyer. The company cannot just offer out more shares, as there are rules and regulations in the Stock Market. There are a finite number of shares of every public company and when there are many more buyers than those who want to sell, someone must step in and offer shares for sale. These transactions all must be done for a Retail Trader in about 60 seconds guaranteed.
Long Term Mutual and Pension Funds hold the bulk of the outstanding shares of stock in trusts and charters, and are unwilling and often unable to sell stocks particularly during a speculative buying frenzy.
Market Makers sell short, so do Hedge Funds and High Frequency Trading firms in order to meet the demand of buyers. Since the bulk of stock is held in long term charters and trusts, this stock is allowed to be BORROWED temporarily to fill the needs of buyers who want to buy the stock. This is the first part of selling short.
Like the person with a reserved room at a hotel, the authorized Market Participant Groups selling short borrow the inventory to sell short the stock in order to meet the demands of the public who want to buy that stock.
High Frequency Trading firms are not the perfect solution, but these firms do provide a huge amount of liquidity in our automated market. They provide the ability for buyers to buy stock and sellers to sell stock, as the High Frequency Trading firms sell short or Buy to Cover. Do they make money? Sure but the risk is also enormous, and many have gone bankrupt providing the “Maker Taker” role.
The most euphoric speculative buying of this kind is at or just before a market goes ballistic, due to the frenzied buying by Independent Investors who enter late into the Uptrend. Then it collapses when price eventually reaches a point where there are no more buyers.
The opposite also happens when Professional Traders and others start selling for profit, realizing the stock is not going to move up any further. Now the stock has more sellers than buyers. As the stock sells down, many Independent Investors panic and start selling their stock, and now there are not enough buyers.
Who is going to buy a stock that is falling in price? Who would take a loss by buying a stock that is losing value? The answer is, those who sell short. In the reverse direction now instead of selling short these same Market Makers, Hedge Funds, and High Frequency Trading firms do what is called “Buy to Cover.” This means they buy the stock back at a lower price pocketing the difference in profits, and return the borrowed stock to the long term giant Mutual or Pension Funds.
The stock rises in value as the Buy to Covers move price back up. Over the long term these episodes where an authorized Market Participant Group must step in and sell short inventory to meet the demand of buyers, and then buy to cover as the sellers sell the stock is repeated over and over again.
Whenever there is a finite amount of inventory and you must look at shares of stock as “inventory,” then there will always be a risk that either there are more buyers or more sellers than there is inventory.
Selling short is legal is because without the constant balancing of the buyers and sellers, the Stock Market would fail to function. When buyers would want to buy but there was no inventory to do so, stock prices would skyrocket and vice versa.
A Little History on Bear Markets
Most Bear Markets are caused by high redemption demands by Mutual Fund Independent Investors. That is why the Mutual Fund industry tries to teach people to not redeem, but to hold through a Stock Market Correction.
The worst Bear Markets in the history of the Stock Market were not instigated by those selling short. They were instigated by Independent Investors who panicked, demanding that their stock be sold and there were insufficient buyers to meet the demand.
Yes there have been throughout our history, those who tried to manipulate the markets by sending out false information that caused widespread panic whereby they sold short to profit. However keep in mind that the bulk of the shares of stock are held in long term trusts and charters. The only people who can move gigantic quantities of stock quickly are the Mutual and Pension Fund Holders who panic, forcing the Fund Managers to sell shares of stock.
A Strong Stock Market Needs Selling Short
There are only a few Market Participant Groups that do sell short. Even among Retail Traders only a small number know how to sell short, and these Traders do not alter trends or have the ability to manipulate the market.
When Independent Investors listen to gurus, hyped up claims, and scams, they put themselves at risk both when they buy speculatively without proper stock market education, and they sell in panic without understanding how the Stock Market functions.
Without selling short we would not have the extremely liquid market we enjoy in the US where a person can buy shares of stock at any time, and that is why selling short is legal.
Selling short is legal, and a necessary part of the Stock Market. It has always been a part of the Stock Market, and will always be a part of it.
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