Monday, October 27, 2008

Short Selling

There has been a lot of blame allocated to shorts. Ajay Shah put his arguments against banning short-selling in "Why ban short selling?". But there are ways where short-sellers can impact the market mechanism adversely.
Now fundamentally, there is nothing wrong with short-selling. Even shorts with borrowed shares are fine and so are naked shorts. Yet, I haven't read detailed analysis of mechanism of how short-selling is causing the market panic.
Generally markets operate on a play between probabilities. The buyers believes probability of gain in buying the object is high, whereas seller allocates higher probability to making a gain by selling. Short-selling pay-off, in-essence, becomes function of two variables - the probability of the bet and size of the bet. Generally these are independant variables.
However, as we deal with wealth concetration risks, the size of bet starts influencing the probability of the event. When big money moves on a bet - it coordinates the operation across futures and swaps in stocks trading in different geographies leading to coordinated move making the bet a self-fulfilling prophecy. This is precisely the pain area. In order to understand this better we need to know:
  1. How the size of bet influences the probability of event.
  2. Is it possible to increase the size of bet and thereby get a coordinated buy-in in favour of the bet without resorting to illegal, immoral means.
  3. Has it happened in some stocks - and if so how.

In sum, the problem is plausible. But it impacts upside as well. Yet, human nature is not adept at understanding or complaining about this "surprising" good fortune. So how can we deal with it?