The first what I learned, when I entered the field of quant finance (15 Years ago): arbitrageurs, hedgers and speculators live in co-evolution. They need each other as counter party.
Then I needed to learn the "secret language" - short sellers and long buyers …. Quite often, I am a short seller of my cash and a long buyer of goods I do not need at that moment.
Shorting
"Short selling (shorting, going short)" means the sale of a security the seller does not own - motivated by the belief its price will decline opening a profit opportunity when buying it at a lower price later. Short sellers usually borrow the security and a number of rules restrict which securities might be shorted how (without borrowing it is "naked short selling").
Its risk is theoretically infinite - it should be used by hard-boiled traders only? Whilst put options another bearish strategy have another risk-reward profile. But both can be used for speculation or hedging long exposure….
The benefits of shorting to the market
Expressing their opinions short sellers play an important role in the efficient matching of buyers and sellers. They run counter to the market's natural bias. Their opinion expresses in a way: the market is overpriced. They help to keep markets in balance.
If we see short sellers as "rational investors" (arbitrageurs) they contribute to close arbitrage.
But
Shorting has extra cost
First, the risk of high fees - dealers who lend the securities may drive the fees high before the short position is closed. Second, the dealers have the right to recall the security loan.
Short selling risk
This is the abstract of the paper of Engelberg, Reed, Ringenberg
Short sellers face a number of unique risks, such as the risk that stock loans become expensive and the risk that stock loans are recalled. We show that these short selling risks affect prices among the cross-section of stocks. Stocks with more short selling risk have lower returns, less price efficiency, and less short selling. Overall, short selling risk adds to the limits of arbitrage and may help explain the low short-interest puzzle
Don't ban short selling
There has been a lot of discussion about short selling. Many blamed the "shorts" whenever stocks went down. Why bans have unintended consequences can be read here. It is like shooting down ideas, opinions, …
Don't Get Shorty
Get Shorty is a novel and film about the milieu in which a loan shark, Chili, in love of movies, who wanted to help dealing with a script, a B-movie producer, Zimm, wanted to buy - thinking this is Academy Award worthy. The problems: Zimm does not own the script and needs other "deals" to get the money to buy it … Finally they made a film about themselves.
Shorts are not bad
We should help them to do their jobs. How to avoid exploding fees may be subject to regulation, but the risk of (multiple) callability as well as mean reverting can be modeled.
Treating multiple callability correctly is essential from valuation to exposure modeling. We put a lot of efforts to do it right in UnRisk.
This post has been inspired by Noahpinion's post.
