Short selling stands as a thorn in the side of companies, yet it is the lifeblood of arbitrageurs and market makers in the ever-evolving world of investing.

The dread of companies and shareholders lies in the ability of short sellers to drive stock prices down, potentially hindering the issuance of capital and impacting investor returns.

Despite these concerns, U.S. regulators have implemented stringent rules to curb short selling, from mandatory disclosures to trading restrictions.

Defining Short Selling

The concept of short selling is simply the act of selling a stock that one does not possess.

Under this practice, borrowers must secure the stocks to facilitate settlement, thus incurring ongoing finance and borrowing expenses for investors involved in short positions.

The Players Involved in Short Selling

Short selling attracts a diverse array of participants, shedding light on the intriguing landscape of those engaged in these activities.

Research from a previous report indicates that while most investors are predominantly “long only” players in the market, a major chunk of trading is orchestrated by intermediaries, despite their seemingly modest net assets.

The symbiotic relationship between market liquidity providers and intermediaries is crucial for the efficient functioning of the stock market.

Chart 1: Emphasizing the Vital Role of Intermediaries in Market Efficiency

For instance:

• Market makers facilitate trade by providing continuous bids and offers, often finding themselves in short positions, thereby aiding buyers in finding sellers and tightening bid-offer spreads.
• Statistical arbitrageurs engage in short-term trading based on the relative performance of related stocks, spurring liquidity transfers that assist mutual funds in executing large orders.
• Futures or ETF arbitrage aligns ETF prices with the actual value of the underlying stocks, ensuring investors obtain fair value when investing in ETFs or Futures for stock exposure.
• Options market makers, both for on-exchange options and OTC derivatives, meticulously hedge their positions by adjusting their underlying stock hedges over time.

The majority of these strategies involve swift offsetting positions rather than accumulating substantial short positions. In essence, short selling by liquidity providers, arbitrageurs, and market makers plays a pivotal role in enhancing market efficiency and narrowing spreads – ultimately lowering the cost of capital for companies.

However, what about long-term investors such as hedge funds?

Long-term investors may also engage in short selling to capitalize on overvalued stocks, intending to repurchase them at a lower price in the future. Hedge funds, estimated to hold approximately $1.5 trillion in net assets for U.S. stock trading, employ hedging and leverage strategies based on their investment policies.

Industry data suggests that hedge funds’ gross U.S. stock exposures could be around $3.6 trillion, with short positions accounting for about $1.0 trillion. Despite actively shorting stocks, hedge funds typically maintain a net-long position.

Chart 2: Estimating Hedge Fund Assets – Long and Short Positions by Strategy

Dedicated short funds, focused solely on shorting companies based on weak fundamentals, constitute less than 1.3% of all hedge fund positions.

Exploring Short Position Data

Reported short position data differs from long position data, with a more frequent but aggregated reporting approach for short positions across the industry.

As a result, companies can identify shareholders but lack the means to identify parties holding short positions.

Table 1: Diverse Position Reporting Rules in the Market

Analyzing Short Position Data Insights

Historical data suggests that short positions across the market exhibit remarkable stability, showing minimal increments even during market downturns.

Further examination reveals that short interest tends to be higher in small- and mid-cap stocks rather than in large- or micro-cap stocks.

Short positions across various sectors indicate:

• The median short position stands at approximately 5% or less of shares outstanding for all sectors.
• Presently, there are more pronounced shortfalls in the consumer and healthcare sectors compared to others.

Chart 3: Short Positions as a Percentage of Market Capitalization by Sector

Additionally, a select few stocks exhibit short interest exceeding 25% of their shares outstanding. This scenario arises due to the utilization of borrowed stocks to settle new “long” purchases, leading to long positions surpassing 125% of their market cap.

Insights into Short Trade Data

Regulations mandate the disclosure of specific short trading data, encompassing real-time details on short sells, enhanced reporting on stock loan activities, and insights into failing trades – all integral components of the operational aspects of short selling.

Table 2: Overview of Rules Reporting Short Trading Activity

Understanding Short Trading Regulations

Regulatory frameworks govern the operational aspects of short selling, curbing this practice during market downturns and prohibiting naked shorting. These rules, primarily encapsulated within the SEC’s “Reg SHO” rule, oversee the conduct of trading activities.