Free Markets and the Purpose of Shorting (by XerxesTraderGF)

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With markets feeling quite top-heavy, I am going to get ahead of an argument that I have heard in the last “real” bear market, meaning the 2007-2009 market*, specifically the argument against shorting. In any market, there tends a very “protective” mindset from market bulls. Most that I have spoken in the past with tend to have a “This market is my property and the value should go up” mentality. As such, they seem to take things a bit personal when market bears tell them “This market is overvalued”.

They seem to get insulted and defensive and look for someone to blame because they can’t believe or don’t want to believe any reasons that their market value could possibly be going down. In their minds, the value should always go up, as it has since the beginning of the US Stock Market (from a nominal perspective). In fact, in many cases, the market “seems” late to digest any bad news at the end of bull markets.

The market keeps running and bulls start misinterpreting this as “This market can handle anything and will keep going”. Then, markets turn. And when faced with reality, market bulls default to several mantras: “This is just a dip”, “It’s a reversion to the mean”, and finally “The shorts are dragging down this market”. And it is this last idea that I take issue with as it is like blaming tv soap operas for your real-life problems. The shorts are market participants, but the market moves as a whole based on the mass market actions.

Around August-September 2008 there was a lot of worry in the market leading up to the October crash (Watch “The Big Short”, excellent fun movie based on book by Michael Lewis that fairly captures the sentiment at the time). The Federal Reserve was concerned about the liquidity/credit crisis and the banks being stuck with their portfolios of worthless MBS’s (broad generalization, but not incorrect statement). This was causing a lot of strain in the market and it was slowly but surely hitting resistance levels and turning lower.

The Federal Reserve was doing what they do best and injecting liquidity into the market. But when it wasn’t working, the discussion eventually turned to blaming shorts for the downturn and even considering making shorting illegal**. CNBC especially (bunch of market cheerleaders) would have several segments every day throughout the day blaming “shorting” for the breadth of the downturn. To be fair, naked shorting was a small contributor to some volatile moves, but they did make naked shorting illegal, which I tend to agree with. Being new to the market at the time and profitable in that year, however, I was offended. But I did not know why until a few years later when I could more fully appreciate and understand markets and their intended nuances.

To introduce my point, understanding what defines a “free market” is critical for any true speculator, be it a day trader, swing trader or anything in between. A free market is intended to bring about true “price discovery” of items for sale in that market. Price discovery means finding a product/service’s true value through means of market valuation.

So, when someone is selling you something, you feel you have paid a “fair price” for it based on the general market value of that item. Such is how a free market works. Now, how do we determine when we have reach true price discovery? This seems like a very fluid idea because it is really determined by how many market participants we have. The more market participants we have, the more we can rely on the valuation of items in that market.

So theoretically then, peak market participation can be considered “critical mass”, meaning we should have maximum confidence in market valuations of those market items. So where does shorting come into play then? Shorting contributes to the intended purpose of any free market by providing for more market participation in that free market, thus contributing to true price discovery.

Now, that was a lot of theoretical discussion in my last paragraph, so I want to make my point in a different way as well. For those who like to hear anecdotal stories, I was near the beginning of my trading career back in 2008 and making some decent money shorting the market.

That summer, I was meeting some old college friends for drinks and as always, once they heard I was a trader, they started to ask me my thoughts on the market. I said “this sucker’s going down and I am shorting every day”. This statement was not intended to be malicious; it was just a fact. If I was buying every day, I would be losing money = no good.

My friends didn’t like that. They blamed me (personally!) for driving down the market. I tried to explain that shorting was just my way of profiting and participating in this market. The market was going to go down with or without me. But then they said “Well it wouldn’t go down so far if you were not shorting”. Again, I disagreed and stated “I am only shorting before/while everyone else is selling. I am also the one buying the stock and propping it up when my trade is completed. So, in a sense, I am actually being more supportive in this market than other participants when they are dumping.”

This was met with a grunt, but I provided this scenario to try to explain from a practical perspective: “Imagine there are 100 market participants in a trading room for one stock with a last price of $50.There are 50 market participants who have bought the stock below $20 and the remaining 50 are bullish but do not own any stock. Those 50 stock speculators want to buy the stock and obviously don’t want to overpay and are putting bids out a $45.

The 50 stock owners, however, are very bullish as well and the lowest offer to sell is $70 (in true bullish fashion, they want top dollar for their valuable investment). Those other 50 speculators may/may not take a bite at that price, but that is quite a big spread. Now, what if in the next room there are 100 speculators who are bearish on that stock? The door to this room opens because shorting is now allowed and those 100 bearish speculators put out offers at $60 and $55, with some even hitting the bid at $45.

Now, immediately, we can see those 50 bullish speculators are quite happy because they are getting more value for their money. They can actually get the stock at a more reasonable price because of stock shorting! On the flipside, what if the price went down? Maybe 5 of those 50 stock owners looking to sell might get that $45 price, but what about the rest? What if the next bullish bid is only at $20 or $10? If shorting were allowed, some of them would likely be covering at $30-$40, thus contributing to better prices.

That is the true intent of shorting: to provide more market liquidity and stability. Where the stock goes from there is anyone’s guess. The bulls are still bullish and the bears are still bearish. The market will determine who is right in the end, but the shorts are actually providing a service!” As expected, this was met with more groans and the conversation moved on to other happier/drunker things.

To summarize, shorting is extremely important, if not integral to a true free market trading system. This is a broad statement and there are certainly caveats and rules needed to maintain an orderly market, but overall, it adds to the market participation which allows for better price discovery and thus market stability. If this market continues into bearish territory as bad as it did in 2001 and 2008, then I would not be surprised if this argument comes up again.

P.S. A second caution I suggest is this: Being a market speculator makes one want to give their analysis to most other people who are interested, which I think is a good thing. It is important to speak your mind but don’t rub it in. No good can come of that. Nobody likes to be told they’re wrong. I will speak my mind when discussing markets, but bulls and bears alike are stubborn folk. I’ll make my point and leave the rest to them. They will either take my advice, perform their due diligence and adjust they’re trading or they won’t. But it’s not up to me to make them believe. The market will do that for me.

* Full disclosure, I did not start trading until early 2008, so anything referring to earlier markets is anecdotal from various conversations I have had.

** While the Federal Reserve did not go that far, they did ban shorting of almost 800 financial companies in September 2008 to attempt to prop things up. CNN Article 2008 SEC bans short selling for financials – Sep. 19, 2008 (cnn.com)