Three reasons why we need short sellers

The GameStop furore brought short sellers into the limelight, with some calling for it to be banned. Julie Wu, professor of finance at the University of Nebraska-Lincoln, says there are at least three reasons why it’s an important part of the financial ecosystem

It’s a useful tool in a bear market

There are two ways to make money in the capital markets. ‘If you are bullish about a company, you can long, but if you are negative about a company, you can short,’ says Julie Wu, professor of finance at the University of Nebraska-Lincoln. Short selling is a good way to make money in a bear market and profit from financial losers. If the short seller gets it right, the strategy offers a high return on investment.

Informed shorts correct overpricing in the markets

‘Short sellers have done their homework – they initiate a short position because they think a company or stock is overpriced,’ says Wu. ‘Short sellers discover negative information about companies. They’re just revealing what they know, which is then reflected in the stock prices.’ Traders need both good and bad news about companies to make informed decisions. In the long run, short selling actually helps protect shareholders from losing big.

It provides liquidity and makes markets more efficient

When the Securities and Exchange Commission (SEC) suspended the ‘short-sale rule’ (which restricts shortselling) from 2005-2007, academic research shows that bid-ask spreads narrowed (reducing trading cost). Conversely, when short selling is constrained or banned, liquidity gets worse. Immediately after the failure of Lehman Brothers in 2008, the SEC temporarily prohibited short selling. As a result, small firms suffered severe degradation in liquidity.