Quit giving short-sellers a bad rap, but don't try it either

Whenever the market plunges or individual stocks stumble, fingers point to short sellers.

Short selling is the practice of betting against stocks in the hopes of profiting if their share prices decline. It's the reverse of what most of us do — buying stocks or mutual funds "long," with the expectation that prices will rise. Traders that engage in short selling want to see their targeted stocks stumble.

"When you short a stock, you're really rooting against the company," said Chuck Wolff, a Scottsdale, Ariz., investor, who called one day recently when the market was tanking. "If somebody dropped a bomb on a company, you'd go out and celebrate."

Wolff, who describes himself as a "retired guy with a small portfolio," doesn't short stocks and wonders why financial regulators allow the practice to continue. Of all the legal tactics utilized by hedge funds and other market participants, short selling has one of the worst reputations.

The negative perception partly reflects the reality that most mainstream investors don't engage in short selling — and shouldn't — as it's potentially quite risky. With regular or "long" investing, you buy shares with the expectation that the price will rise. You receive any dividends that the company pays, and you don't need to worry about paying interest charges to hold the stock.

With short selling, you similarly want to buy low and sell high, but the chronology is reversed. You start by selling shares you don't own — and don't want to own because you think the stock is overvalued. You borrow the shares from someone else, typically a brokerage, so that you can sell them now, with the hope of buying later at a lower price, thereby closing out the position. The proceeds from the sale get deposited into a "margin" account, a type of holding pen for your collateral.

If the shares rise, the brokerage will ask you to put up more collateral in what's known as a margin call. Investors who buy stocks long can lose no more than their original investment. But short sellers face unlimited losses, if the price keeps moving higher. For example, a $10,000 short position in Weight Watchers International on Oct. 16 would have morphed into a $26,900 loss four days later, according to Niall O'Malley, portfolio manager at Blue Point Investment Management in Baltimore. The reason: Oprah Winfrey announced she would buy 10% of the  company, quickly pushing up the price.

So much for the reason you probably don't want to try this at home. Does short selling offer any benefits to the market or society?

Short sellers say they make the market more efficient and liquid, which helps to reduce bid-asked spreads and other trading costs for everyone. They also claim to provide important information — a sobering, contrarian view on a company's prospects — that can lead to more realistic prices and keep valuations in check. Short sellers also say they help to expose poorly run corporations and ferret out inflated accounting numbers and signs of fraud. Enron is an example commonly cited.

Short sellers can do damage by spreading negative news if not false rumors about companies — just like long buyers can. In 2008, the SEC curtailed short-selling in the shares of large financial corporations at a time when the solvency of several such entities was under question and the public was losing confidence in the system.

Yet a study of that and a few other recent examples of short-selling restrictions, by the Federal Reserve Bank of New York, concluded that curbs on short selling "seem to have the unwanted effects of raising trading costs, lowering market liquidity and preventing short sellers from rooting out cases of fraud and earnings manipulation," according to the researchers. "Thus, while short sellers may bear bad news about companies' prospects, they do not appear to be driving price declines."

Short sellers won't win many popularity contests, but it's hard not to see some benefit in what they do. The trading tactic has managed to endure through many prior stock-market downdrafts when sellers became scapegoats. Such grudging acceptance is likely to continue.

Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.