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I read this exchange and the borrowing a car, creating an IOU and selling it made sense. However, can you take the scenario a step further and help fill in more details?

On Monday:

  1. Car owner A has a car
  2. Car shorter B borrows car owner A's car
  3. Car owner A gets an IOU for a car
  4. Car shorter B sells car owner A's car to car owner C

On Tuesday:

  1. Car owner A sells his car (IOU)
  2. Car owner C sells his car

Questions:

Three cars have been sold in the market, although only one physical car exists--does this create selling pressure?

When does car shorter B have to buy a car and replace the IOU?

Does short selling create additional share in the market?

JohnFx
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TBT
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3 Answers3

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Three cars have been sold,

No they haven't - A doesn't have a car to sell. A has to either get the original car back or borrow someone else's car to sell (offsetting his long position with a short).

The other question flow from this faulty premise and are irrelevant.

When does car shorter B have to buy a car and replace the IOU?

Whenever A wants it back (i.e. to sell himself). When selling stock short, the broker is responsibility for returning the "car" to A and either borrowing another car from someone else, or forcing the short seller to close their position (even at a heavy loss).

D Stanley
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The difference is that money and stocks are 'fungible', whereas a car is not. Something is 'fungible' when it is indistinguishable from its replacement part. If I open a bank account with a $100 bill, and that bank puts it in the safe, then whose money do I get, when I walk around the corner in 5 minutes and withdraw $100 from my ATM?

The answer is that the bill I took from the ATM is indistinguishable from the $100 I used to open the account, so it is irrelevant that the bill is not the same physical piece of fibre.

Likewise, for stocks, if you hold your shares with a broker, and someone shorts that stock, the broker may allow your stock to be leant out [with consent likely part of your ultimate broker agreement, in a simplistic sense]. If you then want to sell your share, technically to sell the same one you would need to recall the short, but in reality the broker will just handle the sale by shifting with another client whose share is deemed to have been leant. And because those shares are fungible, this isn't usually a problem.

In a circumstance where there are no other shares to 'switch', then ultimately the broker bears the risk of not being able to make everyone whole again, which is a risk they bear in order to earn the interest they receive from the short seller when they borrow the share in the first place. You aren't really involved in the process at all.

As to whether short-selling creates additional selling pressure - theoretically yes, the additional short-sale would indicate that yet 1 more person thinks a stock will go down. If the price of a share is largely based on the perception of value based on stock transactions, then continued short selling would further drive the image of that stock's decreasing value. If the price of a share is largely based on the perceived value of the underlying company, then it would be unchanged regardless of which transactions occur. In reality, public perception can have a huge impact on value, and short-selling etc. has a larger impact on resulting share-price for small stock or where short-sellers trade in such massive quantities as to drown out other activity.

Grade 'Eh' Bacon
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  • Thanks for answering. In the scenario I laid out, did three sell transactions take place between Monday and Tuesday? I think that's the piece I'm not understanding. It seems three cars were sold, regardless of fungibility and how the broker manages borrowing behind the scene. – TBT Jun 24 '21 at 16:23
  • In your car scenario, for Tuesday Step #1, for owner A to sell their car, they would need to demand their car back from the short-seller [owner B]. Because owner B no longer has the car, owner B would effectively be forced by their broker to go out to market and immediately re-buy the car from owner C. For physical goods this doesn't make sense, but for stock, because it is fungible, owner B would just buy an identical stock for the current price, because the broker would force them to do so. Alternatively, the broker might just give a different car owned by owner D for A to sell. – Grade 'Eh' Bacon Jun 24 '21 at 16:29
  • @TBT Final thought - you are thinking about '3 cars being sold', but forget short-selling for a moment, and think about what it looks like when I sell you a banana, then you sell a that banana to someone else, then that person sells a banana to someone else, who sells to someone else. It would look like 4 bananas have been sold. That's not about short-selling at all, that's just looking at a sequence of events in a different light. – Grade 'Eh' Bacon Jun 24 '21 at 16:31
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    From a 'market pressure' perspective, if it looks like 4 bananas have been sold, you could say two things "4 people were selling bananas, bananas are going down in value!!!" or "4 people were buying bananas, bananas are going up in value!!!" when in reality whether market perception is the first statement or the second is based on whether you sold your banana for more than you bought if for, and so on. – Grade 'Eh' Bacon Jun 24 '21 at 16:32
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    Perceived value or perceived image of a company is a motivation for buying and selling of shares but it is not the driver of share price. The effect of short selling is based on the amount of opposing buy side pressure. If they are equal, nothing happens to price. If there is more net selling volume than buy side volume, share price drops. If there is more net buying volume than sell side volume, share price rises. – Bob Baerker Jun 24 '21 at 17:08
  • Thank you for going into detail! This was awesome and you are amazing for taking the time! – TBT Jun 25 '21 at 02:33
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Your car scenario is a bad example for shorting. You cannot have 3 sellers of one car and only two buyers. In addition, cars are not fungible so an IOU must enter the equation.

After the first transaction, A owns an IOU, B owes the IOU and C owns the car.

A cannot sell his car since he has given it to B to sell to C. However, A can sell his IOU to E. C can sell the borrowed car to D

The end point is that D owns the car, B owes the IOU and E owns the IOU.

With short selling, the shares are identical and therefore they are fungible so there is no need for an IOU to be introduced into the equation.

Does short selling create additional share in the market?

Few people hold them but for those that do, share certificates cannot be shorted unless physically loaned out (cash account shares cannot be loaned out). The remaining shares are electronic entries on a computer. They can be loaned out repeatedly.

There is no such thing as and electronic car in a computer ledger and this is just another reason why your example is a poor one for explaining shorting.

Bob Baerker
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  • Thank you for answering. The car analogy was provided in an explanation by another user in another question. That question was of the first I read when looking into the short selling question. I think you're right. Analogies are rather poor because no thing is exactly like another thing. (In fact it's part of the definition--being "like" something is not being something.) – TBT Jun 25 '21 at 03:45