This isn’t strictly relevant to the subject of this blog, but as I noted in that last link post I’ve been slightly fascinated by the subject of short sellers recently. Since this is my blog, I’m going to talk a little about why that is. Besides, I think understanding fiat currency and financial markets is increasingly relevant to crypto currency, which is one of the reasons I’m learning about them.
In the first instance, short selling is interesting because it’s dangerous. When you buy a stock (or go long) the most you can lose is 100% of your stake. But when you bet against (or short) a stock there’s basically no limit on what you can potentially lose, since there’s no theoretical upper limit of what the value of the stock could rise to1.
Shorting a stock is in some ways like betting on the don’t pass line at craps. At the craps table it’s an extremely rational action. Your odds of winning are actually better than at the pass line2, which is the “normal” place to bet. But you’re betting against the table, essentially attempting to profit from the other players losing3. In much the same way, when you short a stock you’re betting against the success of the company and attempting profit on the losses of those who bought the stock. It’s a negative action. People tend not to like it when you bet against them.
On the other hand, shorting can be useful, or even somewhat noble. In a bubble, shorting a stock can cause a gradual deflation, rather than a pop. As noted in that last post, this might have been what happened to bitcoin after the futures market was introduced. There’s no futures market for other cryptocurrencies, but their price tends to be somewhat correlated to bitcoin (so far), so they also lost value.
The ability to bet against a stock also provides an incentive to find overvalued stocks. One reason a company might be overvalued is because they’re fraudulent or even criminal (Enron is a good example). Hence, there are short sellers who specialise in finding and researching fraudulent companies. They profit by shorting the stock and then publishing their findings to the widest audience possible.
Obviously this also means there’s some incentive for a firm to skimp on the research and just publish negative information about a company anyway. It seems as though something like this might have happened to AMD last month.
If you are interested in the subject of short selling, I found the following documentaries (and one feature film) both entertaining and informative4:
Remember Martin Shkrelli? He was actually a pretty small fish. This short doc is about the short sellers who went after the shark. It makes a good follow up to Betting on Zero, because Bill Ackman was on the other side of this trade.
Watch it: Netflix
This is about shady Chinese companies using a convoluted process to list themselves on the US stock market. It gets into the lengths short sellers can go to in order to perform their research.
Based on the Micheal Lewis book of the same name. Won on Oscar for best adapted screenplay. Manages to succeed as a comedy whilst also telling the story of the 2008 financial crash. Which is impressive. And a little scary.
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- Obviously there is a practical limit. The value of a stock can’t actually grow to infinity. Likewise, my understanding is that stocks tend to grow steadily. They might crash down, but they’re unlikely to crash up. ↩
- At the pass line, the house has an edge of 1.41%. At the don’t pass line it’s 1.36%. ↩
- Of course, the distinction between the pass and don’t pass lines at a craps table is completely arbitrary. The casino just wants you to take the option which has better odds for them. ↩
- All of which are available on Netflix UK, so perhaps in your region as well. Netflix make it really hard for me to check without a lot of messing with my VPN. ↩