Is Short Selling Ethical?

Elizabeth Pittelkow Kittner CFO, GigaOm
Exploring Ethics in Business & Finance Today

In January 2021, an interesting story dominated the news cycle. A group of individual investors on the online forum Reddit noticed that GameStop stock was heavily shorted by institutional investors at a short interest of over 140 percent. These Redditors then banded together to buy the stock and drive up the share price of GameStop, offsetting the bets of hedge funds and causing those hedge fund managers to scramble to cover their bets by buying the stock back at the inflated price. The resulting turbulence in the financial markets became a leading story across the country.

The story left many wondering how short selling works. Here is a brief explanation:

Ella has five ears of corn, which currently cost $20 each.

Heather asks Ella to borrow her five ears of corn for a $5 borrowing fee, and Ella agrees.

Heather thinks the price of corn will go down, so she sells the five ears of corn for $20 each, collecting $100. If the price of corn does indeed go down, Heather can purchase the corn back at a lower price to return to Ella.

Corn prices decline, and Heather’s short sale works—she buys back the corn at $10 an ear for $50, resulting in a $45 profit on the total transaction after subtracting her borrowing fee of $5.

Additionally, Heather can continue to sell the borrowed corn to another short seller, and that short seller can sell to another short seller. Therefore, there can be more short sales than actual ears of corn available on the market.

To understand the GameStop tale, imagine that the price of corn does not go down, but instead climbs astronomically—driven in this case by a large number of small-time individual traders coordinating their buying. In order to return the corn to Ella, Heather has to buy the corn back at a higher price than she sold it for, incurring a significant loss in addition to her borrower’s fee.

Simply explained, short selling is an investment strategy that seeks to benefit from a stock’s declining share price. It is the opposite mindset of most investors, who purchase stocks believing they will benefit from increasing share prices. There are many reasons a stock might decline in value; it might fall because the company is financially unhealthy, or it might fall because the company is healthy but considered overvalued.

One of the most popular stocks consistently being shorted is Tesla. Some believe Tesla’s valuation is a result of a bubble Tesla CEO Elon Musk has created. Musk has consistently voiced his opposition to short selling. A tweet from January 2021 demonstrates his argument against short selling succinctly: “u can’t sell houses u don’t own, u can’t sell cars u don’t own but u *can* sell stock u don’t own?”

Musk’s tweets about companies have a history of significantly moving their share prices. For example, his “Gamestonk!!” tweet on Jan. 26, 2021 helped GameStop’s valuation skyrocket to more than $10 billion in afterhours trading—Musk’s way to stand with the Reddit investors and others purchasing GameStop. He then tweeted a few hours later, “I kinda love Etsy,” which experts believe was the force behind a 9 percent rise in Etsy’s shares the next trading day. Musk and Tesla have been in trouble with the SEC in the past for Musk’s tweets, with Musk and Tesla each paying the SEC $20 million to settle with the SEC. Some have asked regulators to clamp down on his social media influence, while others say it is now a normal part of how markets function. Steven Bartlett, founder of the social media agency Social Chain, has said, “The public markets now have influencers like fitness and beauty do.”

Some people view short sellers in a negative light because they are hoping for stocks to decline, which may be considered cheering for the failure of a company. They question whether it is ethical for fund managers to loan out the shares of stocks on behalf of investors, knowing the borrowing of the shares could affect their value.

The other side argues that the fund managers are maximizing returns on the portfolios by letting others borrow the shares in return for a fee. They point out short sellers’ positive contributions to the market, including providing liquidity, righting a stock that is considered overpriced, providing hedges for other positions, and improving market efficiency. They further argue that short sellers may prevent stock market crashes because they provide a voice of reason during raging bull markets. Additionally, short sellers take on more risk than stock buyers: If someone buys a stock, the lowest that it can drop is to zero. For a short sale, the loss is unlimited, as the price of the stock can increase without a cap. Short sellers lost more than $38 billion in Tesla short positions during 2020 as its share price climbed more than 700 percent.

While short selling itself is a standard stock market practice, not all short selling can be considered ethical. Some short sellers may act unethically in a scheme known as “short and distort,” which happens when someone takes a short position and then uses a smear campaign in the public to attempt to influence a decline in the stock value. The opposite of this scheme on the investing side is called “pump and dump,” which is when someone buys stock (takes a long position) and then provides incorrect information to the public in an attempt to influence an increase in the stock value. These types of unethical schemes have become more popular over time as more people—specifically more small investors—gravitate to online trading.

After its latest moment in the spotlight, short selling is likely to receive more scrutiny. As you consider whether you are for or against the practice, ensure your ethics align with your investment strategies.