A Short Guide To Global Short Selling

A Short Guide To Global Short Selling

The stock markets of the US, Europe, and China face distinct challenges, but all have been rallying, and all of them face the growing phenomenon of short-selling. Each market, however, has had a unique reaction to the bearishness.  

A Short Guide To Global Short Selling
A Short Guide To Global Short Selling

The US appears neutral on the matter. China is encouraging short-sellers, while the ECB is decidedly not. Let's look more closely at why.


First, in the US, the Fed's dovishness and the positive earnings have kept short sellers from having much impact. For the last month they've kept the stock market from making new highs, but there haven't been enough of them to cause the correction some people keep warning us about. Reuters U.S. markets editor David Gaffen: "The Fed and other central banks are in there and there's a lot of monetary stimulus, and, so, there is not as much volatility, markets keep going up, and it's just not much of an environment for short sellers."

In the stock index futures, the limitations on short selling are programmed into the algorithmic trades that constitute about 70% of total volume. Those algos are designed to snap up the lower prices that short selling creates: the short sellers drive prices down, the algos start buying, then the downtrend slows or stops. At this point, short sellers begin to get nervous and cover their positions by buying. This plus the buying of the algos pushes prices back up. And it's funded by the Fed's easy money.

Now, smart short sellers will have protective buy stops in place to get them out if the stock or index future goes against them. The algorithms are programmed to "run" those stops, moving up the price ladder tick by tick and triggering further buying. While no one can say for sure, it's reasonable to assume that some of the intraday rallies in the US stock markets (and other markets) are powered by algorithmic buy programs, particularly those tied to index arbitrage. That's a subject for another day...


In contrast to the US, China's bourses have shot up in ways that seem out of control, especially since many of the purchases are coming from shadowy sources, according to even official sources. “The surge recently has been a little too fast for the regulator’s comfort,” Hao Hong, the chief China strategist at Bocom International Holdings Co. in Hong Kong told Bloomberg on Monday. “The market should consolidate, as it is overbought and part of the market is overvalued.”

China (not surprisingly) doesn't want to leave to chance the when and how of a market correction. But how do you encourage selloffs? At the same time that Chinese regulators curbed the use of so-called "umbrella trusts" to fund stock purchases,  they also made it easier for funds which are hold stocks to lend those stocks to short sellers. Those short sellers can basically borrow the stocks from these funds, sell them at a high price, quickly buy them back at a lower price, then return the stocks to the funds they borrowed them from.

Note how they are are still buying low and selling high, the essence of all successful trades. Short sellers just sell high first, and then buy back at a lower price a short time later. Hence the term "short" sale.

In this case China is proactively facilitating, though not quite encouraging, short selling of overpriced stocks. What's the argument for doing that? Warren Buffett has said (as have others) that money generally finds its way from less capable hands to more capable. Or in this case, from those who are wrong about where the market is going (the longs) to those who are correct (the shorts). But the key is, the money is still in play. It isn't destroyed or lost; it just changed hands. This means that while some financial players in China may lose if and when the stock market (and housing market and debt market) drop, others will profit and in time become able to spend and lend the money they have gained.

That is why short selling is not evil. It's not betting against your country or the economy. It's making sure that money gets circulated and not lost. Yes, it's often zero sum and for the short seller to gain someone else must lose. But that's business. In the long run, the wealth of the market isn't zero sum at all. Used properly, short selling can lead to financing for the future.


The Stoxx Europe 600’s 19 percent rally this year stands in contrast to the net 2% rise in the S&P 500. But the large rally, somewhat like China's big gains, also puts Europe at the same risk of a large correction. Greece's move this week to recover cash from local governments, combined with ECB reassurances that they will keep Greek banks liquid, have pushed off default risks until May and possibly even July. While this may support European stocks for now, the currency is a different story.

The rallying US dollar is causing downtrends in several currencies, particularly the euro. So it's understandable that the euro looks like an easy target for short selling. But not if you ask ECB President Mario Draghi, perhaps the one person who can credibly promise to support the euro if it drops too far for comfort. His message was clear at his recent IMF press conference: “It’s pointless to go short on the euro."

So that's settled.

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