I understand what the actual process of doing so is, but for example I’ve seen people who work on wall street try to reassure us that it’s a normal and healthy part of wall street. I don’t understand how it’s allowed, or why any company would allow it to happen to their shares?
In: Economics
Companies have no control of their shares once they’re in the hands of the public. Shorting shares is a transaction among investors.
And the ability to short allows investors to profit from successfully guessing a company’s shares will fall in price rather than only having a means to bet on a company doing well. And it can help create liquidity in the market of that stock by generating shares for sale that otherwise might not be sold.
To the investor/brokerage lending out the shares, it’s just another way of making money off shares sitting in their account, since the individual shorting the shares is paying them a small amount.
So, the people who own the shares that are loaned out receive a fee for loaning the shares, or more likely the broker gets a fee and maybe passes some of it on to the client. It’s a way to earn some passive income.
As to why it’s allowed at all; simply put, people are free to do whatever they want with their shares. They belong to you, after all. This is the same reason why the company whose shares are being sold short allow it to happen; they can’t stop it. The shares don’t belong to them.
It supposedly helps with fair price discovery, and hinders that when not allowed.
You see anyone who thinks a share is undervalued can expressly state so by buying it.
However if you think a share is overvalued what you would do to express this sentiment is sell it, which you couldn’t do otherwise if you don’t actually have shares. That would be an inherent unbalance.
Otherwise? Because it’s never been forbidden and that is because it never caused trouble before. It used to even be allowed to short shares that you didn’t have at all, without borrowing them. Granted only intra-day since you can’t have a negative amount of shares once you get to clearing, but still that existed.
And even if short selling were disallowed, what would that accomplish really? The short answer is practically nothing. The effect of short selling a share? You can always do pretty much the same through the options market by selling calls or buying puts.
The theory goes something like this.
A company’s share price represents the value of the company. Having an accurately valued company is a good thing for the market and economy. An undervalued company is bad, an overvalued company is bad.
If you think a company is undervalued, you should buy shares on the basis that sooner or later other people will realise this and the price will go up. Buying shares also functions as a signal to the market and pushes the price up, so its closer to its correct value. Later on you can sell the shares for a profit (or hold them for dividends).
Following the same logic, if you think a company is overvalued you should sell any shares you have. But what if you don’t have any shares to sell? It makes no sense to buy shares just to sell them.
So what you do is you short them. This allows you to send a signal to the market that the price is too high, and help correct it.
That’s the theory, at least, as I understand it.
> why any company would allow it to happen to their shares?
* Once a company sells shares on the market…. they aren’t *their* shares anymore.
* They don’t get to control what people do with the shares once they are sold.
* It’s allowed because the government hasn’t decided it’s not allowed yet.
* Shorting in small amounts doesn’t really do any damage.
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TLDR: Stock price does not affect the business, so there is no harm to them. When a person buys a stock they can either sell the stock, or they can *loan* the stock to someone. A loaned stock doesn’t affect the market price and will carry little risk for the lender, but it allows the borrower a chance to make money without having to pay full-price for an expensive stock.
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First, stock price does not affect a business. Making a stock price go up *does not help the business.* Changes in stock price typically happen *after* a business does something good or bad, so stock price usually reflects the business’s recent behavior.
So to answer one of your questions, it isn’t that a the business will “allow it to happen to their shares”; it isn’t part of the business and doesn’t really affect the business.
So now that we cleared up the fact that stock trade is separate from the business:
Usually people think of stock trading as buy-low-THEN-sell-high. But shorting stocks is when you sell-high-THEN-buy-low. That means you sell a stock you don’t own. So whose stock did you sell?
Person 1 *owns* the stock. They did a buy-low-THEN-sell-high, except that they have not sold the stock yet. They are waiting for the price to go up. That means the stock is just sitting there, changing value over time but not circulating.
If everyone who bought stock did this, then there would be no stocks circulating. That means the price of the stock would not change over time.
Person 2 steps in and decides that they want to trade stock, but *cannot afford to buy a stock* at market value PLUS no one is selling the stock they want anyway. Person 1 can lend a stock to Person 2 for a price *less than market value*, and so long as a stock is returned to Person 1 later the agreement is a lend/borrow instead of a sell.
This is healthy because it allows stocks to circulate rather than just sit in a horde. It also allows people who cannot afford current market price to obtain stocks for trading.
And again, none of this affects the business itself.
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