I had a terrific exchange on Twitter related to the news that the most successful hedge fund in the world is potentially trading Bitcoin (or already has, who knows). And it involves whether this means the price will be driven down or not, which is a good starting point for a broader post about shorting stocks, crypto, markets, etc.
First, the obvious motivation for a hedge fund is to make money, and it’s a lot easier to make a billion dollars on something that is worth $100 billion than it is to make a billion off of something that is worth, in total, $1 billion. So the incentive is surely not to just make prices go down.
Implicit to this line of inquiry is a discussion about short selling in general, which gets plenty of financial press in stocks like Tesla, for example. As the most heavily shorted stock of all time, its founder has gotten into huge public feuds with both the SEC and the hedge funds who are attempting to “depress” the stock price.
I think shorting is one of the most misunderstood concepts in financial literacy, with nuances of what it is actually doing missed frequently. One way to look at it is from the perspective of two different situations:
- People about to buy something
- People who already have it
It’s vital to understand there is a symmetry here. If a short seller of Ferraris drives down the price to a thousand bucks, is that bad? Well it depends — if I was thinking about buying one then this is fantastic. I might, in fact, buy two. But if I already bought one and was hoping to sell it at a profit, it’s disastrous.
But you cannot have a narrative that is logically consistent when people buy a stock like TSLA and blame the shorts when it goes down. What’s almost always missed is that short sellers made the stock cheaper for you to buy in the first place. If they didn’t exist, you would have paid a higher price initially, which would offset the lack of price depression later. Nobody really thinks about the fact that they are getting a cheaper price when buying Microsoft stock due to short sellers, but it’s true.
In the extreme cases, it can get dicey. A recent example is Luckin Coffee, which short sellers had a hand in exposing an accounting fraud:
Take again, the example of both situations described above. If you already owned this stock, then this sucks. But what has short selling also done? “Depressed” the price so that any new investor will not have to pay for it at a level that is unfair, unsustainable, or likely both.
Shorting gives the financial incentive to do what the SEC, as a government agency with its resource constraints, cannot do in a comprehensive fashion — ferret out fraud from thousands of different stocks. Uncovering frauds takes resources, and people need to be paid for that time and work which is why shorting is such a successful mechanism in a lot of ways.
Sadly, there are undoubtably more cases like this that will never be caught. For anyone who has watched the pilot episode of the excellent “Ozark” series on Netflix, that question posed from the drug lord is surprisingly insightful: would you fire the worker you caught stealing just once? Jason Bateman’s character’s answer is totally on point — yes, because it’s not the first time she stole, it’s just the first time you caught her. For every financial fraud uncovered by law enforcement or short sellers, there are 10 more that never will be.
As a post script, shorting is a universal behavior that is not confined to financial speculation. People short stuff all the time. I’ll give a software example. One of the famous stories about Microsoft and its initial success was IBM coming to them looking for an operating system. They said they would provide it to them, even though they didn’t have it yet, and bought it later from another company (and called it MS-DOS). The rest is history.
Selling something you don’t have yet is understandably an uncomfortable concept. But people do this type of stuff all the time — and it works and provides a valuable function…most of the time.
