There are numerous problems with short selling. This traces back to the pre-options world, when bearish traders had no way to play a down market other than borrowing stock to sell. It’s high-risk and expensive and most traders would avoid shorting even if it also means losing opportunities. But today we have other solutions.
A second problem with shorting is that it distorts the markets. When an issue experiences a large volume of short covering, it looks like buying pressure, so many traders who are unaware of the source of all those buy orders might believe, falsely, that there is demand for shares. They get burned when the price doesn’t move, or continues downward even in the face of large-volume buying. It is not demand but short covering, and it distorts everything.
The solution? Buy puts instead of shorting stock. It’s cheaper, less risky, and does not require borrowing stock. An argument against this might be that some short sellers want to hold those positions over a period beyond a few months. The solution to this is to buy LEAPS puts.
The fact is that shorting is an obsolete strategy; it serves no good purpose in the market when you can more easily buy puts; and it is lower-risk. I would even favor banning short selling altogether, not with the rationale that it is expensive or high-risk, but based on how high-volume short covering easily distorts the appearance of supply and demand for shares. How many inexperienced traders and investors jump into positions because they see a high volume of buying, not realizing that it is a false picture of what’s going on? Shorting is obsolete because we do not need it today, when long puts present a much cleaner and safer alternative.
About this week’s Heavy Hitter
Michael C. Thomsett is a widely published options author, with six options books in print. He has recently signed a contract with Palgrave Macmillan for a two-book deal, both books on options topics.