On how short selling works and why markets tend to self-regulate


Harry Hutton's blog (warning, very offbeat humour and often very bad language used) isn't where we might normally gather for economic insights. But he notes that, once Fifty Cent had told his army of Twitter followers about the delights of the shares of a company he himself part owns, the stock roared up 290% in one day, following a 120% rise the trading day before.

Mr. Cent may well find himself having interesting conversations with bureaucrats and regulators as a result: but as Harry pointed out, this looks like an excellent opportunity to short the stock. So I contacted the blogosphere's favourite short selling hedge fund manager, John Hempton, and asked (for research purposes, you understand) about the possibility of doing so. To get the response:

Borrow is already a problem.

Fortunately, he then translated this for me: it's necessary to borrow the stock from someone before you can short sell it ("naked shorting" isn't allowed on this exchange) and there wasn't any stock out there to borrow. A little later some became available, but only $5,000's worth. Upon asking why this is so I'm told that this is because vast numbers of people are already borrowing all of the available stock in order to short it.

Which leads us to the value of short selling: that handbag company may well be worth hundreds of percent more than the market was valuing it at before Mr. Cent's endorsement. We might also be seeing a little bubble forming as a result of the fame of the endorser: views may vary. But short selling allows people to make such differences of opinion over value known, allows their opinions of value to actually correct, as they see it, a misvaluation.

If only such short selling had been available to those who were certain there was a housing bubble inflating, eh?

For markets are, by and large, self-correcting, as long as it is indeed possible to speculate on prices falling as well as prices rising.