If last week’s stock market frenzy surrounding GameStop had any public value, it might be that it served as an introduction for many to the once-obscure concept of shorting stocks.
While even most non-investors understand the basic premise of buying shares in the hope stocks will rise, shorting shares—that is, investing in a stock’s decline—is a much more esoteric practice best left to the professionals.
Much of shorting’s mystery comes from its complicated mechanics. To short a stock, investors borrow shares they believe will decline with the agreement to return them at a set time, then sell them on the market. When it comes time to return the borrowed shares, the investors buy them back from the market—theoretically at a lower price—and pocket the difference. It’s a risky maneuver because, while conventional stock investors can only lose their initial investment, a short investor’s losses can be infinite. Again, something best left to the pros.
Shorting may seem like a newfangled Wall Street invention in the vein of other fun instruments like synthetic collateralized debt obligations (don’t ask), but it’s a practice that is almost as old as stocks themselves. Basically, almost as soon as financiers invented stocks, investors were figuring out ways to short them.
The first company to sell shares to the public was the United East India Company (the Vereenigde Oostindische Compagnie or VOC) of the Netherlands in 1602 to finance its trade in spices. According to Jacob Goldstein’s entertaining new book Money: The True Story of a Made Up Thing, the trading company was intentionally egalitarian in its prospectus, inviting “all the residents of these lands” to buy shares. The directors also created a mechanism so investors could sell shares to each other, and very soon, the city of Amsterdam erected a building for the purpose of buying and selling VOC shares, the first stock exchange.
One of the founders of the VOC, Isaac Le Maire, found himself in a dispute with other members, wound up in a lawsuit, and left the company under a cloud. In 1608, Le Maire engineered a way to get his revenge.
Le Maire entered into a futures contract—the type used then and now to protect farmers from price swings in commodities—for VOC shares. Working with confederates, Le Maire agreed to sell a diamond merchant VOC shares for 145 guilders in a year’s time. If the price fell below 145 before the deadline, Le Maire could buy them at their (lower) market price, and was guaranteed a profit when he sold them for 145 guilders. He then made it his business to drive down the price of VOC stock, spreading rumors that the company was over-spending and its ships were sinking.
Shares fell, and the alarmed VOC directors took action. They appealed to the Dutch government, citing “the many widows and orphans” who owned VOC shares, and the government stepped in, making Le Maire’s strategy illegal. Le Maire was wiped out.
That was hardly the end of short selling, though, and over the centuries the practice continued to surface, only to be snuffed out by authorities again and again. Napoleon, for example, made the practice illegal and imprisoned short sellers whose activities he thought were threatening efforts to finance his wars. As recently as 1995, Malaysia’s finance minister endorsed the public caning—that is, whipping with a cane—of short sellers (pdf). That measure didn’t pass, but it did become illegal to short certain companies.
It’s obvious why authorities don’t like shorting stocks: When stocks rise, just about everyone benefits, and corporations and government officials want to encourage their upward trajectory. But as Goldstein writes, “the point of a stock market is not to go up.” The point is to arrive at the best price for stocks, and that means inviting everyone who can bring information to the party, even those who are bringing bad news.