On the surface, it would appear that short sellers only profit off the suffering of others, or specifically profiting of the failure of a company. Although one can interpret it this way, the idea that short selling is unethical is rejected by almost all academics, practitioners and policy makers alike.
The ability to short sell serves a vital role in the financial markets as it contributes to efficient markets and serves an important role in detecting fraud. However, just as with any other financial tool, it's a double edge sword that has the potential to spiral markets out of control or even facilitate market manipulation.
Imagine you go to the casino and there is a simple game. Place a wager on a coin flip, if you call it right you double your money, and if you call it wrong, you lose your bet. Seems like a fair game.
Now let's assume you are only allowed to place a bet on "heads", which leaves you with two choices, to play or not to play. On the surface, this still appears to be a fair game because you have a 50% chance of doubling your money. The issue comes when you look at the incentive for the house.
Based on this simple example, it shows us that allows us to bet on both sides of the coin helps combat fraud purely based on the incentive structures of the scenario. We can extrapolate this to the stock markets in terms of taking a long position on a stock and taking a short position on a stock. People who believe that a particular company is engaging in fraudulent activities are essentially casting their vote and having it reflected in the stock price of the company.
Other than the issue of CEO's getting inflated bonuses as a result of soaring stock prices, the main issue is where that money is coming from.
When a company decides to raise money through a new equity issue, investors will pay a price that is near the current market price of the stock. If investors have reason to believe that a company is engaging in fraud, they may decide to short the stock and put downward pressure on the share prices. That lower price prevents the company from raising more capital from the market until those issues of fraud are resolved. This "invisible hand" type mechanism adds a layer of protection that prevents investors from overpaying for shares of a fraudulent company.
Wall Street Journal on how short sellers helped take down Luckin Coffee just a few years ago
You may ask, outside of incidences of fraud, what other purpose does short selling serve? I would argue that market efficiency is even more important than just the purpose of helping combat fraud.
If you have every studied finance in a university course or through a book, you may have heard of the efficient market hypothesis theory. There are a few different forms of believes but the main idea is that for a market to be efficient, asset prices reflect all available information and opinions of the constituents of the market.
Having efficient markets helps build confidence in the system which promotes participation and allows firms to raise capital to fund new projects. The more efficient the market, the harder it is to beat the market as information is appropriately reflected in the asset prices. This ultimately becomes more beneficial to the passive investor, which just happens to be the retail investor.
Imagine there are two traders in who represent two different views of the market for Tesla ($TSLA) where neither of them currently own any shares. The current price of TSLA is $850 and after careful analysis on the company:
Common sense would say that the price that most accurately represents these views would indeed be $850. At this current price, Investor A will short the TSLA and investor B will buy into TSLA. Assuming they have the same amount of funds to invest, this will leave the price of TSLA at $850.
Now assume that short selling is prohibited. Investor A will stay participate in the trading of TSLA and investor B will buy an amount of shares increasing TSLA's price to somewhere above $850. This is not what we determined as the price that most accurately represents the valuation of TSLA.
The reasoning is that, short selling allows the views of investors who do not currently own the stock the ability to have their views and analysis represented in the value of the stock. Of course most markets do not actually function like this, but this is what makes investing in the stock market so unique, that even non-owners are able to effectively cast in their vote.
In summary, short selling is very important to financial markets. Although there is potential for big investors to engage in predatory activity, the benefits far outweigh the risks and this is also true on the long side.
Read my take on the whole GameStop, Reddit and Robinhood fiasco.
