Short Selling (1)

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As pointed out in earlier blogs, most investors and traders are optimistic (or at least hopeful) that the price of the stocks they purchase will rise.  They make their money when the price increases ("bulls").  A minority of individuals, however, are equally convinced that prices of some stocks are destined to decline.  They invest with the goal of making money on price declines ("bears").  They are called "short sellers."  They do not own (they are "short") the shares they sell in the market.

A short sale is a speculation for a trader, not a long term investor.  The trader believes that the price of a particular stock is going to decline.  The trader borrows stock shares and sells them in the market.  The buyer of the stock does not know that the shares he or she purchases are borrowed.  Usually the shares are borrowed from a stock broker, and the trader agrees to return the shares on demand.  If the stock price drops after the transaction, the short seller then purchases the stock on the open market at a lower price and returns them to the broker.  The difference between the price at which the stock was sold and the lower price paid by the trader to replace them is the short seller's profit.  If, however, the price rises, the short seller must purchase the shares at the higher price and suffers a loss.

The shares that are lent by the broker come out of the accounts of the broker's other customers who actually own the shares being shorted.  If you have an account with a broker and your shares are held by the broker in your account, in "street name", the fine print in your brokerage account agreement, which you signed when opening the account, provides that the broker may do this.  You never know this is happening because any dividends paid by the company during the time the stock has been lent out are still credited to your account.  If you sell the shares during the period the shares have been lent out, the broker will supply them from other accounts to cover your sale.  The broker charges the short seller interest for what is, essentially, a loan, albeit, a loan of shares of stock, not money.  The short seller deposits a percentage of the value of the loan with the broker to provide security that he or she will complete the transaction and replace the stock when required, just like a person who borrows money from the broker (margin) to buy additional stock.

A majority of people have a dim view of short sellers.  The practice strikes an emotional chord in people.  It seems predatory to try to profit from price declines, which represent losses to those who actually own the stock.  Fred Schwed, Jr. gleefully describes this animosity toward short sellers in his 1940 book, Where Are the Customers' Yachts? as follows:

I recall reading a novel about a rich man who was in everything vicious and hateful.  Among his evil attributes the author described how he had made his first fortune.  He had "sold stocks short during a great panic and had thus enriched himself fabulously while hundreds of thousands were being plunged into poverty and ruin."

This quotation expresses well enough the vague, universal indignation at the short seller. (This indignation only exists during and after panics -- during prosperous times he receives about as much attention as do people who practice barratry.  Before October, 1929, no one objected to short sellers except their own families.  The families objected to going bankrupt.)

Vague as the general feeling is, two of its implications are quite clear.  One is that being a bear raider is something like being a usurer or a jewel thief -- that it is an easy way to pick up a fortune provided you are willing to be immoral.  The second is that it is socially harmful.

Before examining these two claims, I must touch on the ancient human tendency to personify general misfortune in some human shape.  While "hundreds of thousands are being plunged into poverty" only the thoughtful ask, "What is happening to us?"  The popular cry is "Who is doing this to us?" and its satisfying sequel --"Just let me get my hands on him!"

At the very moment when we were buying that stock, hopefully  and constructively, looking forward and upward toward better things, those fellows, men without bowels, were selling it and they didn't even have it to sell!  They were looking downward and for worse things.  They thought it would go down and they helped it to go down.  How unnatural!  How perverse!  How cynical!  Why should society tolerate such men any more than those who burn down houses for insurance?

(Author's emphasis in bold)

We will continue our look at short sales in the next blog.
 
Excerpts from Where Are the Customer's Yachts? or A Good Hard Look At Wall Street, Fred Schwed, Jr., copyright © 1940, republished by John Wiley & Sons, Inc, pages 112 - 115

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