Wednesday, 29 October 2008

The risk of rising shares

This is a rather graphic demonstration of the risk that investors run when they are shorting. When you go long you can lose up to 100% of what you have invested, but when you go short the amount you can lose is basically unlimited (because the shares may keep on rising). It demonstrates that one is not the mirror of the other, in addition to showing that shorters are not necessarily better informed (or more rational) than long-only investors (as implied by the argument that shorting can prevent the emergence of bubbles).

UPDATE: Nick says I'm talking ballax (see comments). I might be! A bit.

5 comments:

Nick Drew said...

no no no ! Tom ! yet again you lefties show how little you understand !

(a) the amount you can lose is basically unlimited

not in practice: whomever you are dealing through will have required you to put up collateral against your short position (exactly because of the theoretical problem you allude to, and because you pay nothing upfront except transaction charges), and will automatically cash you out at some stop-loss level before your loss exceeds this amount (or you will need to put up more collateral pronto)

(b) shorters are not necessarily better informed

of course they are not ! (unless they are insiders = Go To Jail) - who ever said otherwise ?

the point is to have as many contesting viewpoints in the game as possible, most definitely including contrarian views, for maximum liquidity, and opportunity for people to act on their views (which needs a counterparty with a broadly opposing view !) or hedge their positions

a market which only allows 'physical long' positions will always be distorted

*sighs* why do I bother ? I dunno ...

[BTW, the VW case is an absolute shocker, and the authorities should be caned for allowing what can only be described as a false market to be operating: how an individual investor can operate responsibly in such conditions is beyong me: the game is being brought seriously into disrepute]

Tom P said...

hhmmm... maybe I was a little slapdash! but still surely the risk in shorting is greater than going long?

my point about the rationality of shorters is mainly aimed at the argument that shorting acts against bubbles forming. I don't think that it does really, and I think that argument also suggests the assumption that those taking a short position know something that others don't (or have a better understanding).

more broadly do we really need any more liquidity? we still get bubbles and corrections with shorting in place, so what does it actually add? all I can see (from the perspective of a long-term investor like a pension fund) is greater costs from increased trading.

Nick Drew said...

OK

(a) your theoretical point is correct (as is my practical one)

(b) efficacy of shorting a bigger qn than I have time to write fully on just now

(c) liquidity ? well just wait until you have an asset you need to realise in a hurry, or an exposure you really need to hedge

liquidity is a public good, a major conduit for efficiencies, a genuinely precious thing

Steven_L said...

Short selling is fun too Tom, you should try it.

If you can't beat them....

Mark Still News said...

Shares are so low now any idiot with enough money could actually make a killing on the stock market in the next 6 months?