Why Is Short Selling Normal?

Small investors trying to “squeeze” GameStop short-selling institutional investors was the most interesting story of the last week. Is sort selling something weird, sinful, strange? No.

• “Normal”, long investment is simple. You buy something to sell it later at a higher price. (Whereby dividends may increase your income). People normally buy something that seems to be cheap, undervalued, to sell it higher. If it becomes expensive, or the valuation gets better.
• Short investment may be more complicated, but the same. It is only reversed in time: The investors sell something first that they think is too high, expensive, overvalued. Intending to buy it back later at a lower price. The difference is the gain of the investor.

Sort selling has a useful feature, it increases the liquidity of the market. Short sellers are providing more supply of the asset. And also more demand if they buy it back. (Close, liquidate their trades, positions.)

The “Let’s Blame The Short Sellers” Game

Some people say sort selling is harmful because short-sellers may put companies or other investors in trouble. They push prices low, making the market depressed. They hurt companies’ reputations, making it difficult for them to raise capital. Banks may seem less solvent. In an extreme case, entire currencies may crash. (See the story of George Soros and the English pound on Investopedia or The Balance.)

This point of view is often emphasized by politicians and officials, especially in times of crisis. They say short-sellers are pushing down exchange rates, in reality, the crisis does. In times of crashes, they used to ban short selling. In first-line for bank shares. In reality, politicians usually look for scapegoats for the crisis, whom they can blame instead of themselves. And they find it among speculators.

Why (GameStop) Short Sellers Are The Best Buyers

Short sellers are shorting weak assets, mostly when they have fallen already. They may speed up the process but aren’t the cause of it. (It is foolish to short an asset with strong fundamentals. Or buy one with a weak underlying value.) But politicians and other persons blaming short-sellers usually forget that they also raise market prices when they close their short trades. “Short sellers are the best buyers”– states an old saying. Because they must close trades, sometimes at any cost.

But then, in the commodity market, by such a line of thinking, the long investors are the bad guys. After all, with their purchases, they make wheat, bread, meat more expensive, aren’t they? And the poor go hungry because of them. By the same logic, short selling commodity market investors would be the saviors of the poor, pushing food prices down. Why politicians never talk about this?

Why Are GameStop Short Losses So High?

By long trades, you can only lose a certain limited amount of money. Unleveraged, 100 percent–all what you invested. With 2x leverage, 200 percent, with 4x, 400 percent. (See also: 6 Effective and Proven Ways to Lose Your Money.) But by short selling, the losses may be infinite. Let’s suppose you short a stock, like GameStop by $40, with a $100 investment. It surges to $400. You lose $900, 9x, nine times of your investment. If you use a 2x leverage, your loss is already 18-times. And all your winning chance was only 100 (or 200, etc.) percent.

So, the risk-return ratio is terrible. One reason there are many more long buyers than short-sellers.

Stock prices mostly surge in the long term. Brief or extended bear markets happen periodically, but the trend shows upwards. That means, shorting the entire market is often a bad idea in the long term. That may have realized many “old-school” investors last year. The economy is in recession, the crisis is deep, but the stock prices surged after March 2020.

When GameStop Short Selling and Long May Be a Crime

So long buying or short selling of an asset are both normal. Excepted if these trades are manipulative. And I’m afraid driving the price of a stock from $40 to $400 in days is a deliberate manipulation. Market manipulation is illegal in most countries.

Price Manipulation Is Illegal, Everywhere

Market manipulation is prohibited in most countries, in particular, in the United States under Section 9(a)(2)[1] of the Securities Exchange Act of 1934, in the European Union under Article 12. The US Securities Exchange Act defines market manipulation as “transactions which create an artificial price or maintain an artificial price for a tradable security–wrote Wikipedia.

In the EU, “market manipulation shall comprise the following activities:

Entering into a transaction, placing an order to trade, or any other behaviour which:

Gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument, a related spot commodity contract. (…) The conduct by a person, or persons acting in collaboration, to secure a dominant position over the supply of or demand for a financial instrument, related spot commodity contracts (…)” (Source: Eur-Lex)

GameStop Short Selling Adventure Getting a Nightmare

I do not intend to protect large investors from small investors. I’m sure big institutional investors can be blamed for thousands of sharp price movements in history. Even for many market-manipulations. But pushing market prices in a direction to take money from others is certainly a crime. It has been many decades. (If this were not the case, the capital market would be even more dangerous than it is now.)

Small investor groups paint an image of themselves to be modern Robin Hood. Robbing from the rich and giving to the poor. But in the end, many small investors can get stuck in the highly overpriced stocks they bought and lose a lot of money. This has probably already begun. (GameStop pre-market today: $225, 31 percent fall.)

Disclaimer

I’m not a certified financial advisor nor a certified financial analyst, accountant nor lawyer. The contents on my site and in my posts are for informational and entertainment purposes and reflecting my collection of data, ideas, opinions. Please, make your proper research or consult your advisors before making any investment or financial or legal decisions.

I’m long in gold miner stocks, uranium miners, silver, platinum, large energy companies, and cryptocurrencies. Short in the S&P 500, Brent crude, and the German DAX at the time of writing.

(Photos: Pixabay.com.)