Is short selling bad? | Stocks and bonds | Finance & Capital Markets | Khan Academy

I think we know enough about
shorting now that we can start thinking about whether it’s a
good or bad thing to have in financial markets. And what I’ve done here is
I’ve drawn a hypothetical stock chart for a company. This time right here. This is the price
of the company. And let’s just say that this is
a chart in a universe that doesn’t have short
sellers in it. So this is all– here a lot of
people are buying the stock, then over here some people,
maybe they get freaked out or whatever, they start selling. And then more people buy. So demands a little higher
than supply, so the price goes up. And that just generally
drives the volatility. Now in a short selling world,
what would happen? Let’s let’s think about two
scenarios, a short seller who makes money, and a short
seller who loses money. So a short seller
making money. What would a short seller making
money have to do if this is the stock chart. Obviously, they don’t see the
stock chart beyond the day that they’re actually making
the trade, but in order to make money they’ll actually–
they’ll have to short at the local peaks. And they would have to
cover their shorts at the local minimum. So a good short seller– or
you can even say a perfect short seller would maybe short
here– let me make it a different color so you can see
where he’s acting– would short here and then
cover there. And he would make that much
money on that move. And then he would wait a little
bit, wait for the stock to get expensive again
in his mind. And he would short here, and
then he would cover here. This would kind of be–
obviously it’s very unlikely that someone could so well pick
tops and bottoms. But let’s say they’re just really
good at their analysis and figuring out market psychology
and things like that. And they would just
keep doing it. They would short here
and cover here. What would that actually
do to the stock? The green line was a
reality where you had no short sellers. Now if all of a sudden you
allowed short selling, and they had these guys come into
the market who know how to make money shorting. He’s shorting up here. So what would shorting do? Shorting is you’re borrowing
the stock and selling it. So he’s creating extra supply
for the stock, right? So what he would be doing at
this point, by shorting, is he would actually be lowering
the price at this point. So let me draw the curve. So if there’s a bunch of short
sellers acting in this range, it would actually
lower the peak. Because you have a bunch–
you have some more aggregate sellers. So the price wouldn’t
go as high. And then on the other hand,
these short sellers have to cover right here, right? They’re going to cover
their position. So at the low point you have
more aggregate buyers covering a short position, is just you’re
buying the stock to pay it back, because you borrowed
it earlier. So here you would have more
aggregate buyers. And then at this point, once
again you have more aggregate sellers, so the price
won’t go as high. You have more aggregate buyers
here, because the short sellers need to cover, so the
price won’t go as low. And so forth and so on. And the bottom line is, a short
seller who’s making money on the stock market, so
they’re shorting the stock at peaks and covering the stock
at troughs, is actually reducing the volatility
of the stock. And that’s good for everybody. That’s good for the company’s
management. That’s good for the actual
shareholders of the company. And obviously it’s good for the
short sellers because they are actually making money. And this is actually true for
anyone making money in the stock market. That they’re reducing
volatility. What is a long– just a regular
investor– or I guess you could call them a trader
since they’re buying and selling– a regular trader would
make money by buying here and selling here. So really a regular trader
is not any different. A regular long trader is no
different than a short seller, it’s just the order in which
they’re buying or selling. But anyone making money is
buying at low points and selling at high points. And anyone doing that is
helping to reduce the volatility in the stock. And even if you’re a long term
buy and hold player, you would rather sit and hold a stock–
you would rather be a holder of a stock that does this,
than a holder of a stock that does this. Now there are a lot of players
both on– you could call them traders because they’re buying
and selling on a regular basis– that aren’t kind
of doing this. Maybe they’re piling on the
shorts at a low point and they’re causing the stock
to go down even more. And then, when the stock starts
to move up they get scared and they buy it, and
it causes the stock to move up even more. And it increases the volatility
of the stock. But these guys are being
penalized because they’re losing money. The people who sell at low
points and then buy at high points, and increase
the volatility, they’re getting killed. They’re falling every day. So it’s not like you
have to create some penalty for those guys. Their penalty is that
they’re just bad traders, they’re bad investors. And they’re just going
to lose their shirts. So if you’re assuming that none
of these traders in any way manipulating the markets
or spreading false rumors. Anyone making money on a stock,
as long as they’re not manipulating it, on either the
short or the long side, is actually a net asset
for the stock. That they’re actually reducing
the volatility of the stock price. I guess another thing to think
about and this is just from a– it’s good. They’re reducing the volatility,
so from that point sorting doesn’t seem too
bad, for me, or in general to the market. But another way to think about
it is, kind of where are all the incentives in the markets? Who has an incentive to be
positive on a stock? And who has an incentive to
be a negative on a stock? Or to scrutinize a stocks? Well, the biggest, I guess
cheerleaders, for a stock, and it depends on their degree of
kind of credibility or ethics, would be the company’s
management, right? These are people– it would
be company’s management. These are people who obviously
run the company, but they have the best transparency into the
financials of a company, and they tend to be shareholders
of the company or get compensated based on
how the stock does. So these guys have every
incentive to be positive. And, as we’ve seen multiple
examples of, whether you’re talking about the investment
banks, or Enron, or Accenture, they’ll often kind of hide the
truth when things get bad. So these guys are definitely big
time positive on stocks. Then, let’s see, who are the
other players or the influencers on financial
markets? Well, a big one is the
financial press. And I’ll write it out here so we
can have a discussion about whether they are pumpers of
stock or whether they tend to be more– whether they tend
to scrutinize things a little bit more. An important thing to think
about with the financial press, and next time you watch
CNBC– and I don’t want to just pick on them– is how
do they make money? Do they make money by
finding things that are wrong with companies? Do they make money by
making you money? No, they make money
by selling ads. And then the next question,
obviously, is who are they selling ads to? Are they selling ads for mops? Are they selling ads
for bicycles? No, they’re selling ads to
financial services companies. So people who want to manage
your wealth, stock brokers, mutual fund companies, anyone
who can advertise. And this is key, too, because–
I don’t know, you’re probably not aware of it but
hedge funds can’t advertise, so they’re not consumers of the
financial– or they’re not customers of the financial
press. The only people who are
customers of the financial press are money managers,
financial planners, and things like that– brokers,
mutual funds. And all of these guys benefit
when stock markets go up. Obviously mutual fund managers
will– they tend to be long only, so they only want
things to go up. Stock brokers– you might say,
oh you know, a stock broker can advise you to go long or
short and they just care about how many transactions
you make. But in general, more and more
people put money into the stock market in rising
markets. In a market like you’re seeing
right now over the last year, people are pulling out– you
could say oh, maybe people aren’t doing more transactions,
but the general net effect is, people
are pulling money out of the markets. So when they’re pulling money
out of the markets, brokers are getting less transactions,
they’re managing less money. And that’s also true of
the money managers. And there’s also just another
ancillary side effect, is when markets go down and people
become less excited about the stock market, people stop
watching CNBC and CNNfn. And so even those few ads that
are for mops and for bicycles and for cars will get
fewer viewers. So in general the financial
press, at least in my opinion, is squarely in this camp. And then we can talk more, you
know, sell side analysts. You’ve probably heard the term
sell side and buy side. But sell side analysts are the
analysts that work for the major brokerages and investment
banks, who publish those reports that you see in
those ratings, a buy rating on IBM, or whatever. And the reason why they call
them sell side analysts is because they work for the people
who are essentially, on some level, selling– you could
either view them as they often offer securities, or they
offer financial services to, often the companies
themselves, or to potential acquirers of the companies. Or they’re selling their
services– I mean, usually– they’re brokerage services, so
they’re trying to get people to transact, they’re actually
brokers on some level. But clearly these guys, their
incentive, since their customer tends to be the
management of companies, is to be very, very, very positive. And you should say oh, there
are other people who, their whole job is to scrutinize
these people. Like, the government. But if you think about it once
again, the government likes a rising stock market. It takes– when people’s 401k’s
are rising, the economy does better, the government
doesn’t have to worry as much about other types of social
benefits, and unemployment, and things like that. So in general, and if you want
to be more, I guess, if you want to be more critical of the
government, you could also say that they are, to some
degree, very close to the management of these firms and
to financial companies. And to some degree, these guys
have significant clout in terms of lobbyists– and, well
actually, I would even say the bankers, too. They have significant clout in
terms of lobbying, and just access to government,
generally. And government drives the
regulators, so these guys are also on the positive camp. And then finally you have
the ratings agencies. And the ratings agencies mainly operate in the debt world. And we’ll talk more
about that. But, if you can scrutinize a
company on the debt level, and you say oh wow, this company
really isn’t that good, they’re not going to be
able pay off its debt. That kills the stock. But once again you have to
realize that the rating agencies are also paid by the
bankers, so the rating agencies are also– have the
incentive to kind of not see things when things are bad. So out of everyone in the
financial services, or the financial world, that we’ve
talked about right now, they all benefit when stocks
continue to go up. Even when they go up beyond what
they really should go up. And even if they all kind of
know that things are a little bit too expensive. Or this management team might
be a little shady, or they might be covering
up something. None of these people
really have an incentive to expose it. And the only people who do
are the short sellers. These are the only people who
really have, arguably the sophistication and the time and
the monetary incentive to really look and scrutinize
what management is doing. To really look in the books
and kind of put a puzzle together, or put a bunch of
pieces together to come to the conclusion, wait, the numbers
that management is spouting really don’t add up. And because of x, y and z,
this company really is overvalued. So to a large degree they are
kind of on society’s side in preventing management from kind
of being overly bullish. And I don’t want to sound like
someone who just broadly is defending short sellers. There is a class of short
sellers that I think would be bad, and that’s the people who
are spreading false rumors, and being market manipulators. So there’s just the
general market manipulation, or rumor mongering. And that definitely is bad, and
to some degree, if you can show someone is doing that,
there should be some type of penalty for doing it. But even there, and just it in
my experience participating in public markets, if I had to
pick– if I had to pick between the left side of that
chart, between this side of this charge and this side of
this chart– and if I had to say who does spread
false information when it does get spread? I think often times management
is a little bit more guilty of it than the short sellers. In fact there’s very few times
that I’ve seen where the short sellers are– there’s some
negative thesis on the stock and where it really comes out
to be completely untrue. Although, there are examples,
and those short sellers, I don’t think are really in the
mainstream Anyway, I don’t want to meander too much. I realize that this video
has already gotten long. But I thought it’s a nice,
useful discussion to maybe think a little bit about whether
short selling really is all that bad, even if you
are a long investor.

44 comments on “Is short selling bad? | Stocks and bonds | Finance & Capital Markets | Khan Academy

  1. All these comments and not one poster says anything about margin or margin requirements. If u don't understand 'margin' and how it works then you have NO business being involved with short selling. You must be well versed with all the rules of this game or basically your toast… I am no expert but. shortiing(as its also known) is generally not for novice or small time traders! Learn the rules and see for yourself then you'll understand! Thx.

  2. But what about the competition?

    Imagine a young upstarting company with an innovating idea or technology and holders of a patent that could radically change the way we live.

    Because that new company starts out small, can't a large competing corporation just destroy their market value using short selling in a bad way, because they have 1000 times more financial power. They will lose money initially, but eventually the competing company bankrupts and they gain the patent. Isn't that a problem?

  3. this is the shit. it's taken a while to find a good learning source about the important things to learn about and who would have known it's khan academy who ive been helping with my maths degree for ages now.

  4. you know you're getting a thorough look through when the categories are positive and scrutinitive. rather than some textbook giving you some unreal positive and negative categories.

  5. Any buying and selling no matter whether it is day traders or short sellers DO manipulate the stock, since their behavoir does affect the stock price. If this behaviour were taxed or curtailed it would slow it down and make the price of the damn stock more stable and more reflective of the real value of the company.Stock value then has more to do with what the traders do ratiher than what the company does, the quality of its products and the value of the service it provides to society.

  6. This doesn't sound very logic to me. When people short sell, the price drops, but they do it because it was already high. So I don't think it's true that the price doesn't reach the high value and remains more constant below. It would reach the high value and suddenly drop when people short sell it. Same thing when it reaches bottom. Am I wrong with this? Can anyone explain? thanks

  7. In addition to my previous comment I also think about it like this: if the stock price is falling, everyone panics and wants to sell their share…but who do you sell it to? who's so "stupid" and buys the share? The only person I could think of is a short-seller, who buys it to make profit out of it. This transaction makes the share price fall even further, creating even more volatility. Am I right about this?

  8. Lol, you have to let go of any preconceived biases, first. Then, do a mental exercise–if there are more sellers when prices rise, and more buyers when prices fall, it means that the underlying asset will move in less volatility (along its trend). It's pretty easy to follow the logic…

  9. Yeah, if you think about it, companies sell their stocks at their IPO, and rarely do they buy or sell their own stocks after that (compared to all of the other trading of that stock that goes on).

    That's why the performance of the stock has little to do with the value of the underlying company. It has to do with the perceived value of the company, which can be guessed at in different ways.

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  12. Theoretically you may be right but what we are seeing now more and more is that these market manipulators are mostly the short sellers. Spreading negative news is WAY easier on the internet than spreading positive news. Hedge Funds are typically the short sellers and they can EASILY manipulate the market because of their huge amounts of capital at play. Bankers play nice with short sellers by the way. Sell side analyst for competing stocks can also scrutinize. The question remains inconclusive.

  13. No, the answer to the question is conclusive. Take it from someone who understands finance and mathematical econometrics thoroughly – short selling is a good thing for the market. His analysis is correct, both theoretically and practically. QED.

  14. By that logic all trades lessen volatility. Then there is zero volatility and all stocks are flat. Extremely wealthy shorts can destroy any company overnight and overtime without risk. It has happened and will continue to happen.

  15. Awesome video, you rounded the whole thing up really well, i wouldn't have commented, but i felt i had to give you credit for putting it so …simply i guess..

  16. Short selling probably does not reduce the volatility of the stock. The reason being is that it simply involves a person wishing to get rid of an asset that they think it's overpriced any person who wishes to acquire that ass that thinks it's underpriced. It should reduce the bear ask spread but even that is a zero sum game. Having stared that, shortselling is mostly the stuff of fools. Reason being is that stocks rise on average which is magnified even more by the fact that inflation decreases the value of the Currensy exposure while you're short so that you have this double headwind constantly eating away at a short position.

  17. It depends if market maker players like George Soros manipulates the market using short selling. Also HFT – High Frequency Traders manipulate to scrape the cream off their own created distortions.

  18. Whether you buy or sell it impacts the momentum, a big buy will raise the price and attract buyers increasing the upwards momentum. And a big sell will have an opposite effect increasing downward momentum and deter buyers, in reality hurting the company.
    And I think that it's morally och OK if you already have a stake in the company and own shares and want to get out.

    Imagine a rich person/company buying up most of the milk in a country for what it costs now (lets say 1 Euro) and selling it at a fraction of its price (0.6 Euro). No one would then buy milk at the original price, that would reduce the price so much that the milk company may be able to cover its costs and getting close to bankruptcy.
    Short selling also involves borrowing (real or virtual depending on the exchange) so the person/company could just borrow/use credit to get all the milk.
    You might think that it's bad deal for the one selling it at a low price, but if he manages to buy the same amount of milk even cheaper from the milk company (like 0.4 Euro) because of the downward momentum of price that he triggered, then that margin would earn him 0.2 times the big amount of milk involved. Earning him a lot of money but potentially putting the milk company out of business.
    If the same speculating had been done using buying/going long then it wouldn't hurt the company and would potentially make him the same amount of money.
    For the reasons above I think it's morally bad to Sell Short. Would you as a person like to be "sold short"?

    Plus I don't agree with the logic in the chart part of the video. It's sort of like saying that if you move a box 1 meter to the left and then 1 meter to the right it should end up at the same location. Well not if you're at the edge of a cliff when you move it 1 meter to the left and it falls off the cliff, and then you move it 1 meter to the right, it probably won't be at the same place even right-to-left-wise (if you get my point).

    That's the difference between theoretical/"paper-trading", that in real trading your action affect the market depending on the volume and timing and other factors.

    I liked the second part though and it was nice to see some one with a different point of view.

  19. It is easier to predict a downfall of a stock than an upturn , therefore , it is easier to make money short selling .

  20. I think this whole series about shorting, and mortgage-backed securities is a required watch before watching "The Big Short" lol

  21. Management drive is attract new faces, maintain progress and above all, never admit downfall.
    The latter being their biggest downfall.

  22. So you can create paper assets by shorting silver contracts with a 5 year mining deficit. This is fungable with forex and oil etfs

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