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Stocks

How Short Selling Makes Markets More Efficient

Most investors buy and hold stocks to capitalize on long-term growth. But sometime traders need to be able to short sell a stock too. That means they need to sell a stock they don’t already own.

Most investors buy and hold stocks to capitalize on long-term growth. That’s called a “long” position. When those purchases settle, the cash in the investor’s account is reduced and stocks owned increased. When that investor sells stock, the opposite happens.

But sometime traders need to be able to short sell a stock too. That means they need to sell a stock they don’t already own.

Who shorts stocks?

Being able to short sell a stock is important for market efficiency.

There are plenty of valid reasons for short selling:

  • To keep futures, options, swaps and ETFs priced at fair value. In order for a liquidity provider to hedge a bid in the derivative, they need to be able to be short sell the stock. That way, their short stock + long derivative position is a riskless hedge.
  • Market makers providing tight spreads (bids and offers) on corporate stocks may also end up net selling to a buyer.
  • Statistical arbitrage and long short portfolios may need to be short one stock and long another, sometimes for days or weeks, until short-term imbalances return to normal.
  • Data also shows a small proportion of investors run dedicated short portfolios, which are designed to short sell stocks that are expected to underperform.

Overwhelmingly, research into short selling proves that it makes markets more efficient. Not only does it reduce the trading costs and mispricing of derivatives, it also adds liquidity and improves price discovery on single stocks. Interestingly, research also suggests that long sellers impact stocks more than short sellers.

How do you short sell stocks?

Market rules are designed to minimize failed trades. Given a short seller doesn’t already own the stock, those traders need to first “borrow” the stock from a long-term holder before initiating a short sale.

Chart 1a: Settling a typical trade

Buying a stock

Source: Nasdaq Economic Research

Just as the bond market has a mature “repo” market, stocks have a well-developed stock loan market too. In fact, many long portfolios benefit from the fees they earn for loaning their stock. That often helps investors reduce their portfolio management expenses.

In order to protect the owner who loans their stock from credit risks, loans are also over-collateralized and additional margins can be called if needed.

Chart 1b: Settling a short sale

Shorting a stock

Source: Nasdaq Economic Research

A related topic, a “short squeeze,” means a stock’s price goes up (not down). Short squeezes can happen when shorts suffer losses after a stock has rallied instead of falling and sometimes triggering margin calls.  Closing shorts means buying stock and returning stock-loaned to investors.

Just how shorted is the average stock?

Looking at short interest across all stocks provides some interesting insights.

Firstly, mega-cap stocks have relatively low short interest. But so too do nano-cap stocks. While stocks in the middle, the mid-cap stocks, tend to have much higher short interest.

That seems to indicate that hedges for futures (liquidity is overwhelmingly concentrated in S&P500 futures) don’t account for most short interest. Although ETFs like the hyper-liquid Russell 2000 ETF, IWM, which trades $4 billion per day, may contribute to additional short interest.

Chart 2: Average short interest by market cap

Average short interest as % shares outstanding

Looking at shorts by ticker

If we look at short interest as a percentage of shares outstanding for each stock, we see a wide range of short interest around those averages. Although only 11% of stocks are more than 10% short, while a much larger 27% are less than 1% short. That’s especially true of micro-cap stocks, which may indicate that stock loans are less available for many of those stocks.

Chart 3: Short interest by ticker and stock price (colored by market cap)

Short interest as % shares outstanding

Chart 3 also shows that there is little correlation across stock price. The trends are roughly flat across stock price and the R-squared of each market cap group is less than 1%. In short, stock price makes no difference to how attractive a stock is to shorts.

The cluster of stocks priced at $10 is also interesting. Many of them are SPACs which are like private equity vehicles with dry-powder for acquisitions. They are typically priced at $10 and hold only cash—so their valuation usually holds until an acquisition is announced.

What does this all mean?

Many issuers fear shorts. That makes sense; shorts not only sell stocks, they sometimes do it because they expect the price to fall. But there may be less to fear than one thinks.

Interestingly, short biased hedge funds have the lowest returns of major strategies tracked by HFRI.

Chart 4: Short selling hedge fund strategies trail the pack

HFRI 10 year performance of core strategies

There are also relatively few stocks with very high proportions of shares shorted and there are also guardrails that limit short sellers’ positions, especially when stock prices fall, as we saw in the recent COVID-19 selloff.

For the most part, shorts help provide tighter spreads to buyers. They also help make derivatives more efficient and pull liquidity from the broader market to offset single stock demands.

You might not like it when they’re selling your stock, but for investors, short selling is an important part of the market ecosystem.

Phil Mackintosh

Nasdaq

Phil Mackintosh, Nasdaq Chief Economist, has 30 years of experience in the Finance industry, including roles on the sell-side, buy-side and at accounting firms, which included managing trading, research and risk teams. He is an expert in index construction and ETF trading and has published extensive research on trading, ETFs and market structure.

Read Phil's Bio