Short-sellers profit from declining share prices, but they make the stock market better for everyone.
They profit from pessimism. They hope for bad things to happen. They wipe out shareholder value. Those are just some of the criticisms leveled against short-sellers. Such attacks, however, are misguided. Indeed, in the world of investing, few practices are as maligned – and misunderstood – as short-selling.
In essence, short sellers borrow a company's shares and immediately sell them with the expectation that the share price will fall. If it rises, they can face massive losses. But if the price does fall, short-sellers buy back the shares at a lower cost, keep the profit, and then return the shares to their original owner.
The most coveted resource on Wall Street is information, and short-selling is an important – and ultimately beneficial – source of market information.
Markets that allow short-selling (several countries, including France and Japan, have banned it in the past) provide added incentives for people to discover valuable information. When research leads some investors to negative conclusions, short-selling allows them to profit when they correctly anticipate the market's response.
But this strategy does not harm the wider market. Indeed, short selling helps make share prices more accurate.
That's because negative information is as valuable as positive information in directing stock trends. Selling short merely lowers a stock's price sooner than it would otherwise fall. It cannot force the price down for long if fundamental market circumstances do not support it.
Short-sellers have been portrayed as heartless opportunists, benefiting from bad outcomes. But their role in quickly correcting mistakenly optimistic beliefs promotes a healthy market.
Selling short is common in all sorts of businesses. For example, farmers who sell on a futures market when first planting crops are essentially selling short.