Short sellers help stocks find their true values and expose fraud, despite the hate they receive

  • plays several important roles in the market, including accurate price discovery and early detection of fraud.
  • Analysts warn that social media and meme stocks could bring about changes to the practice.

The recent events surrounding meme stocks and GameStop's short squeeze have put short selling, one of the oldest practices in the stock market, directly under the limelight.

"Short selling has always existed," said Ihor Dusaniwsky, managing director at S3 Partners, a firm that specializes in analyzing short selling data. "It's been a part of the normal trading process on the exchanges since exchanges started. We've seen short selling increase recently in a broader spectrum of names."

Short selling has always been a controversial practice, often blamed for causing drops in the market. The Securities and Exchange Commission eventually stepped in to better regulate short sales after short sellers were once again blamed for a market decline in 1937.

"I think the main reason people dislike short selling is that something just feels bad about profiting from someone else's failures," said Sasha Indarte, an assistant professor of finance at the University of Pennsylvania's Wharton School. "Short sellers gain when someone else loses. It's like if you took out an insurance policy against your neighbor's home and your neighbor's home was destroyed."

Short selling is when investors, mostly professionals like hedge fund managers, borrow shares of a stock from a broker and sell them in the hope of buying them back cheaper. If the stock drops, the investors make a profit off the difference when they return the shares to the broker. A short squeeze occurs if the price goes up, and the investors need to rush to buy the stock to cut their losses.

Countries in Asia and Europe have banned short selling during times of economic uncertainty. Some studies, however, have shown that a ban on short selling actually does more harm to the market than good.

"During the financial crisis between 2007 and 2009, regulators have actually banned short selling temporarily in response to the large drops in the stock market. Regulators have since expressed that they regretted this policy action," Indarte said.

Price discovery

That's because, despite the negative sentiments toward it, short selling plays a pivotal role in the market. For instance, short selling allows for more accurate price discovery, a key function of stock markets.

"If it wasn't for the short sellers, there'd be a lot of long shareholders buying and bidding up stock that really had no value," Dusaniwsky warned.

Exposing fraud

Short selling has also allowed for early detection of fraud.

"There are companies that are potentially not doing the right thing, engaging in fraudulent practices, and shorting a stock oftentimes brings some of those things to life," according to Jason Snipe, founder and chief investment officer at Odyssey Capital Advisors.

"People don't get upset when they're making money on the upside. They look the other way on bad corporate behavior," argued Jim Chanos, a prolific short seller in the U.S. market. "But when people start losing money, boy do they get upset."

However, in light of recent events, experts warn that social media and "meme stocks" could bring about changes to the practice. And recent data shows hedge funds have dramatically curtailed the activity because of the threat of getting caught on the wrong side of the trade from a retail mania.

"Going forward, with the advent of social media and some of the other mediums that people are looking at these days, the SEC probably needs to be thoughtful and reasonable here," said Snipe. "And I think they will be as far as their examination of how we look at shorts in the future."

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