Short-seller, friend or foe?

It depends on whom you ask. Conventional investors often think of shorts as their scourge, heaping negativity on honest companies in a concerted effort to drive the shares lower. Shorts defend themselves in Darwinian terms, saying if not for companies' own dishonesty, they would never thrive.

One way short-sellers are rarely portrayed is as a force for greater harmony on Wall Street. But a few new studies indicate they are just that, providing liquidity in periods of high volatility and serving as an important hedge for trades that if unchecked could create real panic in the market.

John Bollinger, president of Bollinger Capital Management, said short players generally don't have much impact on stock prices either way. "Outright short-sellers are a relatively small part of the process," he said, adding that most investors hedge their bets.

And a recent study by Ed Blount, executive director of Astech Consulting in New York, bears this out. Blount, who examined a variety of data over a 60-day period this summer, found that most short-sellers are arbitrageurs using offsetting bets to hedge their risk.

Traders often sell short securities in which they have long positions for hedging purposes or tax reasons, and such sales neither depend on nor are motivated by bad news. As a result, Blount said, most short selling doesn't have a negative impact on stock prices.

Nevertheless, short-sellers have been a convenient punching bag this year, blamed for fueling the declines in the market, particularly from May to July and from August to October, when the Dow Jones Industrial Average fell 25% and 20%, respectively.

Brett Gallagher, vice president of U.S. equities at Julius Baer, said short-sellers have added to volatility, with share prices tumbling sharply as short interest grew and rising when short interest waned. (Short interest is the total number of shares that have been sold but not yet bought back.)

Still, Blount argues that short sales often lag movements in the stock market rather than lead them, suggesting that they are likely to be the effect rather than the cause of price changes.

Filling a Need

What's more, Blount says, short-sellers add liquidity to the market, and may have helped to prevent a more serious downturn over the summer months as many traders rushed to cover their positions.

"If one result of the short-sellers' value-neutral trades was to generate liquidity, it could be that the Dow did not fall so far as it might have in the wake of an illiquidity-induced panic," he said.

Gallagher agrees that short-sellers can contribute to liquidity but he pointed to other evidence that short sales potentially have a negative impact on stocks.

A recent study in the Journal of Finance found that Nasdaq stocks that are heavily shorted experienced negative and significant abnormal returns in the period of June 1988 until December 1994. A separate study by Harvard Business School documented a strong negative relationship between short interest and subsequent abnormal returns in a large sample of NYSE/Amex stocks.

The results can be interpreted to indicate short-sellers create artificial downward pressure on stocks, or simply that shorts are usually right. Because of the potential for theoretically infinite losses, some analysts believe that these traders do extremely thorough homework and are in a good position to alert investors to problems within a company.

Still, Gallagher warns that people should be wary of who they're listening to.

"The good short-sellers are really good," he said. "But there are some people in the business I wouldn't trust to balance my checkbook."

While the subject is controversial, Bollinger says a market is better off with short-sellers than without them.

"In China, there are no short sales or put options," Bollinger said. "The only thing you can do is buy a stock if you think it's going up and sell it if you think it's going down. It's a one-sided market and people get very frustrated."

"A balanced market with both short selling and a vibrant options market actually gives players an optimal set of tools to adjust their portfolios," he said.