The Ethics of shorting. TLDR: It's ethical.

What is shorting?

(Short-Selling Basics)

Shorting is borrowing a stock and then selling it with the expectation you can buy it back later at a lower price and return it.

In the wake of the financial crisis and Melvin Capital's heavy shorts of GME, citizens and Congressmen alike believe that shorting is wrong.  The layman's consensus seems to be that a short seller takes a bunch of short positions and then trash talks a company to make the price magically go down, then cash in.

But it's not magic.

The profit motive

If I make shoes for a living and it only costs me $20 in materials and 10 hours of my time to make a pair of boots is it wrong for me to charge $200 for them?

Most long-term investors look for companies with good financials and good prospects then buy into them and hold them for the long term.  This can provide the companies with money to improve their business, selling shares to raise it.  Typically, the road to profit is a long one so some investors and most traders then go on to tell anyone who is listening how great the company is with the goal of hastening the "inevitable" rise in share price.  This is legal as long as you disclose you have an interest in the shares you're hyping.  And if it really is a great company, then traders and investors from all walks of life will want to hear about it.  The rise isn't always as "inevitable" as some would have you believe.

The other side of that coin is that a prospective investor will research a lot of companies and decide not to invest in them.  Sometimes you'll come across companies that are circling the drain or involved in fraudulent business practices.  Should you just move on at that point?

Short sellers say no.  Short sellers find those bad companies and put their money where their mouth is, selling shares to people who want them at a price the buyer believes is fair but substantially higher than the short seller believes is warranted.  Then, frequently enough, some short-sellers get on every media platform they can and tell anyone who's listening how bad the company is with the goal of hastening the "inevitable" drop in share price.  This is legal as long as they disclose the interests they have in the company.  And if it really is a bad company, then traders and investors from all walks of life will want to hear about it - to exit their positions quickly or just to avoid it.  But the fall in share price isn't always as "inevitable" as some would have you believe.

I don't see the difference between anyone talking up their position beyond the substance of what they're saying - which is often pretty vacuous.  If a talking head can convince you, that's on you as well as the talking head, not just on the talking head.

Traders and investors try to buy low then sell high, short-sellers try to sell high then buy low.  The profit motive drives both. 

Dogpiling on the decline

The layperson sees a company that seems to be doing fine, short-sellers bet against the company, then short-sellers tell everyone about how bad the company is, and (when it makes the news because it's either working or correct) the share price declines.  They see this as a bad thing because they're missing the relevant details.

Here's a big one:

Nothing happens to a company when it's share price drops to zero.

Other than it's shares being worthless anyway.   I think people get confused because they forget about causality.  If your car is no longer functioning or existent no one will give buy it, and it's value is nearly zero, people understand that.  But people not wanting to buy your car doesn't make your car stop running, people seem not to get that.

Just because today your car won't fetch anything on the open market doesn't mean it never will.  If you car keeps providing utility and value from it's operation eventually the market will also recognize it's value.

All this is also true with companies.

If the share price drops below it's fair value, then a bunch of investors like me will want to buy it because the company will be fine in the long run.

If the company is "bad" (poorly run, fraudulent, in massive debt, unprofitable, etc) and was selling it's shares to the market to stay afloat but not actually turning the business around, and we all suddenly notice at once that it's a bad business when THAT failing company's share price drops to zero it will go bankrupt pretty quickly.  Whereas before it was going bankrupt slowly.

If the company isn't selling shares to finance operations then a drop in the share price won't shut them down.

Enron didn't go to zero because of short-sellers, it went to zero because it was a fraudulent business.

Mark Baum didn't crash the mortgage market, he just bet against the house of cards before the final gust of wind.

That's basically what successful short-selling looks like.

The Growth company & Start-up complication

The purpose of shares is essentially financing.  A new company needs money to grow and buy the things to make it grow up big and strong.  So founders go to the market and sell the promise of a bright future to fund that future.

Sale of shares in these businesses finance operations.

Will they get there?  Who knows, that's why IPOs are risky.  For every Johnson & Johnson, Microsoft, and Amazon there are many more who fail.  Like Pets.com

What if the promise of a bright future isn't, exactly, true?  The founders say they're going to make the world a better place, but if they fail to deliver on their milestones why would you keep giving them money?  What if the company is doing something amazing with your money, but there's no way they'll be able to pay you back.

Here's a real-life example: What if your company turns celluloid from films into oil and you herald it as some great and amazing revolutionary technology. Well then I'm calling BS.  Your shares are selling for $5 each?  I can't wait to short your BS "company".  Your business will never make money and your idea is stupid.  Someone lend me some shares quick so I can short this dumb business before everyone else figures out how stupid it is.  In the end I didn't kill your stupid company, you did when you disagreed with physics.  What I did certainly didn't help you, but your "business" was a scam and I was under no obligation to help you.  Me shorting you didn't make your business fail, your business failed because it sucked and would never make any money, I just noticed and enjoyed the fall.

So I guess I am guilty of schadenfreude.

WSB & GME

Gamespot isn't a start-up, but it says it's going to re-tool itself into relevance.  That's why I believe it needs to issues shares at these high valuations to finance that reform.  I'll do a GME specific write-up in the coming week, but from what I can see it's been losing money, has no future, and retooling at this stage is futile.  It's like Borders Books.  It did have a pretty nice past though, but that isn't always indicative of it's future.

And if GME does sell shares those WSB folks won't see their money back for a long time, if ever.  The sharp few might've bought in early with a nice short squeeze play, but I'm guessing share prices will drop out after the next options due date or sooner so the smart money has probably exited.  Your rallying cry went into their pockets.

I'm not judging, I'm just saying.  Dying on a hill for something you believe in is something our society views with pride.  But you should know, that you are going to die on that hill if you keep standing there.

I have a feeling this whole thing will remind me of Coke II in 6 months.

"We are not that dumb, we are not that smart"1

How short-selling works

• There are two sides to every trade.
• Short-sellers need to borrow the shares they sell.
• The entities lending the shares receive interest payments from the short-sellers until the shares are returned.
• The entities doing the lending to the short-sellers have bought shares from the market.
• Market makers and shares bought on margin are the primary sources of lent shares
• Short-sellers sell their borrowed shares into the general market.
• The shares "in the market" necessarily exceed the number of shares that exist.
• The excess is balanced by obligations of short-sellers to return shares to the lender.
• In the GME/WSB situation, short-sellers sold more shares into the market than there were shares in existence.
• Short-sellers played themselves.
• Short-sellers get cash immediately for the sold shares
• They are required to hold some amount in reserve to demonstrate they can return the borrowed shares
• If the price of the stock goes up, this reserve amount increases.
• Even if the price will eventually go down, they need to show they can close the contract at any time and therefore without enough cash on hand can be forced to close their positions (or sell them) at a loss.
• Short contracts can only be closed when shares are returned to the lender.
• Using straightforward math, the expected value of all shorts is negative.
• A short seller can only make the difference between the sale and buy price
• If a stock keeps rising, no matter how improbable, losses are can be infinite (if not hedged)

Secondary effects and reflections on Short-selling

• The market (necessarily) doesn't know where the shares came from
• A large number of short sales is the same to the market as a large number of regular sales, so the share price is likely to fall, at least temporarily.
• Momentum traders exacerbate the effects of all price movement
• A low relative valuation, regardless of outstanding shorts, is a buying opportunity for value investors.
• Value investors love shorts when it makes shares cheaper to buy
• A value investor who has bought shorted shares is unlikely to sell them at or below their acquired price.
• A short-seller is required to return the same number of shares it borrowed to the lender, regardless of price.
• A value investor will be willing to sell shares at some point at or above fair value
• The market determines fair value, but it can be a bumpy ride.
• When short-sellers are temporally wrong they often need to cover their positions
• They can only get shares from the market
• Any rush on shares in the market is likely to drive up share price, at least temporarily
• Shorts are generally only for high-end market participants who:
• have access to a lot of capital
• often don't have the same leverage restrictions as the retail investor
• When the highly leveraged get it wrong it can create a liquidity crisis throughout the market
• Selling leveraged assets makes their value fall
• requiring more sales
• ... requiring more sales from more assets
• .... requiring more sales from more assets
  
• To avoid a leverage crisis highly capitalized entities will often save the over-leveraged to avoid the contagion of the systemic risk created by over leveraging.
• The over-leveraged also have many assets across many asset classes, so actually meeting their obligations could cause a drop across all those asset classes during the forced sales.

In summary:

Short-selling is a useful tool to signal and profit from a bad business while exposing fraud and information not commonly available.

Short-selling is a restraining force on over-exuberance and excessive optimism acting as a check on ridiculous and unfounded high share prices.

Without short-selling there would be no incentive to fairly value any financial instrument.

Bad financials & business practices make companies fail, short-sellers capitalize on that.

Short-selling and falling share prices don't make companies fail, they are just relatively consistent and generally accurate portents. 

The steam whistle doesn't make the train come.