Absolutely nothing in the world of investment stirs the emotional juices quite like arguments over the virtues of short-selling. Traditionally, if traders believe prices are going up, they buy the assets and wait for the rise. If they think the price is going down they sell the asset and wait for the fall. But what if they don’t hold the assets in the first place and they believe prices are about to drop? How can they take advantage of the falling prices? – selling high and buying low – but selling what?
On the face of it, investors and traders should be allowed to take positions on the price falling even where they do not hold the underlying asset. Short selling was devised as a mechanism to accommodate such a situation. Traders who believe the price will fall can “borrow” the asset and sell it into the market at the higher price – buying it back later at the lower price. Initially, this worked perfectly and provided additional liquidity to markets in both upward and downward swings. But the facility can be abused!
In tranquil markets traders are tempted to trade assets in order to generate some activity in the hope of making a profit. But with short selling they also have a means of driving prices lower for no good reason other than profit. “Isn’t that what capitalism is all about?” we hear you cry. Certainly, an elevated share price might deserve to be corrected to a lower level but what of a share price at fair value – does that deserve to be driven lower? Many believe that the dynamic of buyers and sellers allows for the market to find appropriate “fair-value” levels. While others see the intervention of high frequency trading as a disruptive distortion to normal demand and supply.
US authorities recognised the difficulties and introduced the uptick rule. This was intended to ensure that a price couldn’t fall off a cliff due to short selling, by imposing a restriction that short sellers must trade at a price higher than the last traded price. So, unless there are sufficient buyers to push the price higher, short selling to lower levels cannot take hold. Somewhat brazenly the uptick rule was abandoned in the mid-2000s just prior to the last market crash. It was re-imposed in 2010 with a twist.
The uptick rule now applies only in situations where the market price is already 10% lower than the previous day’s closing price. This regulatory condition allows the software programmers behind high frequency trading to short sell down to 9.99% without difficulty. Where markets are relentlessly pushing higher this is a profitless and futile exercise. But if traders have any doubts that prices are going higher, then the allowable downswing is potentially very easy money.
Opinions on short selling will continue to differ. High-frequency trading exacerbates the debate; but the fundamental reasoning remains sound. Market manipulation is definitely fraudulent, but the honest expectation of lower prices should not be arbitrarily punished.