“Don’t it always seem to go, that you don’t what you got ‘til it’s gone”

                                                                                                                                                             - Joni Mitchell

Short selling is the practice of selling shares that you don’t own. The short sales are covered by borrowing stock from existing shareholders. While those involved are sometimes vilified as “cowboys” with “licenses to kill”, the existence of covered short selling is an essential component of a deep and liquid share market. Further, investors can use the information about short selling to improve their returns.

It can be distressing to watch a shareholding savaged by short selling. When a portfolio suffers losses it’s tempting to play the blame game. And it’s not just shareholders. A number of CEO’s have complained about short sellers.

Gerry Harvey of Harvey Norman is among the most prominent. Mr Harvey has clarified his remarks, pointing out he is not against the practice itself but against short sellers making, in his view, false claims about the company. This is in line with the view of the regulator ASIC. “Rumourtrage” is the spreading of false information about a company with the intent of influencing the share price, and is obnoxious to a fair market.

However individual investors may be surprised to read that short selling is essential to the proper functioning of the stock market. Many of the instruments used by professional investors rely on the ability of traders to short sell shares. Futures, options, CFDs, convertible bonds and other hybrid instruments are made possible by the ability to short sell.

The variety of exposures available through these derivative instruments mean a much wider group of investors can participate in the market. Another implication is that much more sophisticated investment strategies are available. The depth of opportunities in Australia’s share market encourages more participants, meaning more liquidity for buyers and sellers. Additionally, fund managers can increase portfolio returns by lending their stock to short sellers and receiving a fee.

Some investors may react to these facts with a shrug of the shoulders. Investors tend not to appreciate the importance of liquidity until there is none.

This writer stood as a market maker in options on the old ASX option trading floor a quarter of a century ago. At the opening of the market in Rio shares there were regularly no bids or offers. Because market makers can short sell, and need to know where the underlying share price sits, there was a mechanism and an incentive to “find” the market. Starting with a bid at (say) $40 and an offer at $41, the market maker would edge them closer until “real” buyers and sellers entered the market. Without short selling it may have taken hours to find the opening share price for a major stock like Rio.

Investors can gain insights from the activities of short sellers. All short selling is reported to ASIC, and ASIC keeps a register of the short interest in a stock. This information is published daily on the regulators website, and can be utilised by anyone who can navigate a spreadsheet.

A significant short position in a stock can be a sign that some professional investors believe a stock is overvalued, either outright or in comparison to another instrument. Investors holding stocks that feature on the most shorted list may take this as a prompt to assure themselves of the investment case in that stock. Secondly, where a number of stocks from one sector of the market are high on the list it speaks to concerns about that industry.

Thirdly, changes in the short position of a stock can give investors clues about changes in market thinking. While decisions about the suitability of any stock is a matter for the individual these aspects of short selling may provide clues.

Finally it’s important to remember that nobody knows the future, including professional investors. A positive for longer term investors is that where a heavily shorted stock announces good news it can start a “melt up” in the share price, delivering extraordinary returns in a short period of time.