When Is Short Selling Fraudulent?

stock haircut

Amid the controversy over GameStop, many cynics argued that something sinister was clearly afoot because the hedge funds had shorted 138 percent of the outstanding shares. In this article, I’ll review that particular claim, as well as another seemingly dubious practice, so-called naked short selling. My conclusion is that shorting more than the total outstanding shares isn’t perverse or fraudulent, whereas naked short selling—depending on the context—might be.

A Review of Short Selling

Before diving into the specific variants, let me first explain the basics of short selling and why it can be a healthy activity in a free market. (In this section I reproduce material I published in an earlier mises.org article.)

In general, those who speculate in the stock market provide a “social” service—if they profit—by steering asset prices to their correct levels, as I explain in this article. If investors believe a particular stock is underpriced, they can buy shares of it and then unload them once the stock has met or surpassed what they view as its “proper” level. In this way, the speculators push up the (initially) underpriced stocks, helping to correct the “error” in the original price structure. Notice that it doesn't matter whether the investors who notice the initial underpricing own any of the stock at the outset.

However, things are different when an investor believes a stock is overpriced. If the investor happens to own shares of the stock in question, the obvious move is to sell some or all of the position, which both earns a relative gain for the investor and also speeds the downward move in price.

If this were the end of the story, there would be an obvious asymmetry in the market’s ability to rely on the dispersed knowledge of experts in diverse fields. Namely, it would mean that the only people who could act on their belief that a stock is overpriced would be those who already own the stock.

Fortunately, the market allows short selling, where someone who has zero shares of a stock can, in effect, sell shares and end up holding a negative position. In other words, a person “going long” might end up holding a hundred shares of a stock, whereas someone “going short” might end up holding minus a hundred shares.

Suppose stock XYZ is trading at $50, but Sam the Speculator believes tomorrow’s news will contain something very unfavorable for the stock. Further, suppose that the rest of the market isn’t seeing things the way Sam is. Sam can borrow, say, a hundred shares of XYZ from Harold the Shareholder, sell them today for $5,000, and then wait for the news to hit. When it does, and the stock sinks to $40, Sam buys back the hundred shares for $4,000, and returns them to Harold (along with a fixed fee). Harold is better off, because he earned the fee; the price drop would have hit him in any case. (If Harold wants to unload his XYZ stock as the price drops but before Sam returns his shares, then Harold himself can short a hundred new shares and end up no worse off than he otherwise would have been.1) Meanwhile, Sam has netted $1,000 (minus the fee) from his superior foresight.

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