Short-selling is long-buying's less-popular, opposite-day twin. Though it gets a bad rep, short-selling actually does the market plenty of good. How is that possible?

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu give listeners a rundown on how shorting works (and why it's generally a bad idea for individual investors), how the practice helps the market and long-buyers, how less-scrupulous short-sellers take advantage of the system and give everyone a bad name, what naked short-selling is and why it's so heavily regulated, and more.

A full transcript follows the video.

This video was recorded on July 20, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 20th, and we're doing the long and short of shorting stocks. I'm your host, Dylan Lewis, I'm joined on Skype by senior tech specialist, Evan Niu. Evan, what's going on?

Evan Niu: I'm going to Vail this weekend with some friends. That'll be fun. As I mentioned last week, the kids are out of town, so we get an adult trip to the mountains.

Lewis: Your kid-free weekend, enjoy. Before we let you get to that fun weekend with your friends, we have a listener question. I'm pretty excited about this one. One of our listeners, Kelly, wrote in. Kelly had a question about shorting stocks. Here it is: "Can you lay out the case for why allowing people to short stock is a good thing for the market?" I think this is kind of fun -- it's an investing concept but it's also a philosophical discussion of the financial markets.

Niu: Yeah. Shorting is a big part of the market.

Lewis: Before we get into the actual question itself, why don't we do a quick rundown on, one, the mechanics of shorting and how it works, and two, the risks -- huge disclaimer, we don't like people shorting stocks, generally. I want to emphasize that as we go through the show. Us saying that you can short is not necessarily an endorsement that you should short, although it is a good thing for the markets. 

If you're interested in shorting, most people only are on the long side of the financial markets. If you own shares of a stock, you are long in that company. Shorts, on the other hand, borrow shares from the longs and sell them, hoping that the share price goes down.

Niu: Right, and later on, they hope to buy back those shares at a cheaper price and return the shares that they owe. It's the flip of buy-low-sell-high, it's sell high and then buy low -- ideally, that is.

Lewis: For a quick example here, let's say I own ten shares of Industry Focus stock, and let's say that it trades for $100. Evan, you want to short Industry Focus. You think this podcasting thing that's going on is just a fad. So, you decide, "I'm going to borrow shares from Dylan, share them immediately," and as you do that, you're going to pay a loan for the time that shares are not in my account, not being held by me, for the time that you're borrowing them. 

Fast forward one month. Two different scenarios here. Scenario one: you were right. Podcasting falls off the map, and with it, Industry Focus does. Maybe people are sick of my voice. They don't want to listen to the show anymore. Our downloads dip. We'll say that shares go down to $50. Let's run through the mechanics of shares at a lower price with a short position.

Niu: If I borrowed them at $100, you sold them at $100, then this podcasting thing proves that no one listens to podcasts anymore, the stock goes to $50, then I'm profiting $50 by selling it at $100 and buying them back at $50 later on. 

Lewis: When you return the ten shares to me, I care about the number of shares I have, not so much the value of the shares. That's how shorting works, and that's why we're able to create these opportunities. Scenario No. 2, we'll say that IF downloads skyrocket, the show is doing awesome, shares go up to $150. In that case, you are not so happy.

Niu: Right. They must love your voice, then. [laughs] 

Lewis: I guess so. People must be happy with it.

Niu: In that scenario, I sold them at $100, but the stock went up, and now I have to buy them back at $150. I'm buying them at $150 and selling them at $100, and I'm losing $50.

Lewis: In the grand scheme of the entire purchase, that would be $500 in losses. Scenario two does a little bit to highlight why we tell individual investors they should probably stay away from shorting stocks, but it can get a lot worse. The reason for that is, when you're short, you have limited upside and unlimited downside. In scenario two, shares went up to $150. There's no theoretical limit on how high the shares could go. Say we have a banner quarter at Industry Focus, downloads are doing awesome, advertisers are really happy, shares go up to $250. In this case, you can actually lose more money than you originally put in to the short position.

Niu: Right. If you're long, the worst thing that you can happen to you, in extreme scenarios, the company goes bankrupt and the stock goes to zero. But if the company does really well, there's no ceiling on how high the stock can go over time. If you're taking a short side of it, the risk-reward profile is basically inverted. The most you can make is if the stock goes bankrupt and goes to zero, that's your maximum upside. But if the company continues to do very well, the sky's the limit.

Lewis: There are a couple of other reasons why we think investors should probably stay away from shorting and leave it to some of the more sophisticated folks and money managers. The big one for me is, shorting goes against the broader trend of growth that we've seen historically in the U.S. stock market. You look back, U.S. stocks as a whole have returned somewhere between 5-7% annualized going back decades. If you're short, you're fighting against that general motion of growth in the U.S. economy and the financial markets, and that puts you in a tough position. 

Niu: Right. Certainly, if you pick a specific company, it's a little bit less risky, if you have a good argument on a short thesis. But there are plenty of people out there who short the broader market. I definitely agree with you there. Since the long-term trend of the market is up, it's not something you want to sit on for years and years on end, a short position on the broader market. But, if you're predicting a short-term or temporary pullback, that's typically where you see people betting against the broader market.

Lewis: People are generally short individual companies, but when you are short an individual company, you have to be right not only about the company that you're shorting, but the time that you're shorting the business. That's because when you're short, you are paying out a loan fee for the entire time that you're maintaining the short position.

Niu: Not always, I should mention.

Lewis: Oh. Most of the time? Does that sound right?

Niu: It depends on the supply of short shares. A lot of stocks are very heavily traded, a lot of liquidity, a lot of supply shares. Those don't really have any fees. Typically, it's when they're hard-to-borrow stocks. Any stock where there's a really high demand of short interest and not a lot of supply, that's when these fees come into play, typically.

Lewis: You have fees potentially eating into whatever returns you might be getting from the short position, and you also have to worry about share price rising as this is happening. When it does rise, you may get what's called a margin call.

Niu: In which case, sometimes you have to put more money in to feed your short position.

Lewis: The struggle is, you may be right in your thesis of the short position, but the market may take longer to realize what you're talking about in your short position thesis than you can maintain the position. There's that classic quote from John Maynard Keynes -- the market can remain irrational far longer than you can remain solvent. That's one of the struggles with being short.

Niu: Right. You have to get both your thesis and the timing right.

Lewis: Yeah, which is difficult. I think the other main drawback of being short is, profits from shorting are earned and taxed, generally, at the short-term capital gains rate, because it fixates on how long you're actually holding the security that you are going to be taxed on gains or losses of. So, shorting is generally not a tax-efficient way to invest.

I think Kelly's question is getting at the idea of, the stock market is this proxy for general economic health, and economic growth is a good thing for everyone. We want to see businesses succeeding. Why would we want to allow people to bet against the market? It's a good question. I think there is this cynicism and this skepticism around short-sellers. They get a bad rep.

Niu: Short-sellers actually do provide several different types of benefits to the broader market. The first one is, it gives an incentive to be bearish on a company. History has shown the market can get ahead of itself at times, as can individual stocks. There are also times when unscrupulous companies are actively deceiving investors and the public. Both of those scenarios provide shorts with really strong incentives to conduct really deep due diligence and various research, to see if a stock is either being overhyped or overvalued, or if they're engaged in outright fraud, in some cases. 

It's also worth noting that if you're long, you should also appreciate those angles, too. It's always good to hear the other side of the argument. If you're invested in a stock that is potentially in one of these scenarios, wouldn't you want to know if there were cracks in your long thesis, or if the company was doing something illegal and wrong? This group of short sellers is probably more motivated to go out and find these problems than you are, if you're a long investor, because we're all biased.

A few good examples of this would be the big banks and financial institutions during the Great Recession. Listeners should absolutely read The Big Short by Michael Lewis if you have not. It came out a long time ago. It's one of my favorite investing books of all time. It really highlights the short side of the financial crisis. Another good example would be Valeant Pharmaceuticals, which was actually a Fool rec previously, a while back. They were doing some fraudulent activity with an affiliated pharmacy distributor that included millions in illegal kickbacks and stuff. 

Another good one, while it never made it to the public markets, Theranos is this huge blockbuster story of a company that was deeply engaged in defrauding investors. I'd also recommend listeners read the book Bad Blood that just came out. It's written by the Wall Street Journal investigative journalist that really uncovered the whole thing. It's a really good book, it's gripping. It's like a spy novel, but it's real life. The journalist wasn't short or anything -- because, again, you can't short private companies -- but it's still a cautionary tale that there are companies out there that do bad things. Shorting is an important part of giving people this incentive to really call out those things.

Lewis: A very basic economic principle is that people respond to financial incentives. So, if you're giving people a way to make money on a bear thesis, they are going to go about looking at companies a little bit more skeptically than they might otherwise. It provides a counter argument or devil's advocate to a lot of bull theses that we see out in the market.

Also, if you look at the big picture of market participants, without short-sellers, you don't have a lot of people that are looking for fraud. You only have regulators. Market participants dramatically outsize regulators. So, having people who are doing due diligence and looking for cracks in the pavement of some of these businesses is a good thing for all investors, because it will help uncover some of the frauds that are out there.

Niu: Right. That leads into another point on the mechanics side of it, there are some other benefits there, too. Shorts contribute a lot to this process of price discovery, which is basically the market trying to figure out what a stock or company should be worth. If you only had long investors, and the only people that were selling were long, there would not be as many market participants out there trying to determine how much these things should be worth. 

They also provide additional liquidity, since they're borrowing shares from longs that otherwise may not be trading those shares as frequently. While there are plenty of active long investors that trade in and out, there are also a lot of buy and hold investors that will just sit on those shares for years. Having those shares loaned out and traded provides additional liquidity. This is especially true for securities lending fully paid programs, where you have a hard-to-borrow stock that can get you that short fee. If you're a long-term investor and you want to earn a little extra return, you can actually voluntarily and consciously choose to lend out your shares to short sellers in order to get a little bit of return. Obviously, you still hope they're wrong in the scheme of things.

I've also worked with a lot of active traders in the past. I remember that, a lot of these times, these investors are just playing small moves on either side, up or down. They're not really philosophically committed one way or another. They're just making a short-term speculative bet. It has nothing to do with actual fundamentals. That ties back into the liquidity aspect of it.

Lewis: There are a lot of benefits to making short selling available in the market. You have price discovery, you have, potentially, fraud detection, and you also have the liquidity benefits. 

That said, there is a dark side to shorting. I think this is where a lot of people have a bad taste in their mouth with shorting. It's a tool, it's a market tool. Like almost any tool, it can be used for good things and bad things. Having covered the good, I think when short-selling gets a bad rep, it's because people are speculating or deliberately moving the market for their own gain.

Niu: You can have people put out these sensationalist reports alleging fraud, or making these really wild accusations, and they might benefit on that move, but the underlying "research" may not be that legitimate. In which case, it's borderline market manipulation.

Lewis: Yeah. The investment industry gives a lot of latitude to analysts to create their theses and state them. That's good, because it allows people to make cases that they otherwise would not necessarily be able to make. Unfortunately, there are some short sellers out there that are high-profile enough that, when they decide to publish a research note, it not only goes up on their website, but it gets widely reported on. They wind up on MSNBC or one of the other business channels. And that event alone is enough to push down the stock. 

So, you have some high-profile short-seller saying, "Shares of Industry Focus are going to go down 10%. It's way overvalued." Well, it'll probably go down 7% in the next day or two, as they're making all of these claims. What becomes unseemly about this activity is, very often, the people that are pushing these reports more on the fringe of short selling have initiated positions before they actually make those reports public. That gives them a self-fulfilling prophecy approach to investing.

Niu: Yeah, they just front run themselves.

Lewis: That bothers a lot of people, rightfully so. I think that is, in the grand scheme of the market, a very small portion of overall transactions and activity. But it is frustrating nonetheless, because you don't want people doing anything to manipulate the market. Unfortunately, like I said, shorting is a tool. It can be used for good and bad.

Niu: Right. Those are just noise, short-term moves. At The Fool, we tend to focus on the long-term. We're more interested in, are the fundamentals actually right, or is there deeper fraud, not just these short-term swings that some people do. It's so infuriating when they do that.

Lewis: One other problematic element of short selling is the idea of naked short-selling. Evan, do you want to run through that really quick?

Niu: We mentioned earlier, the regular selling, the way that it's supposed to be done is, you borrow the shares first, then sell the shares. So, you own these shares, you come back later and return them. 

Naked short-selling basically skips the first step. It's illegal, I should mention. It's basically, you're selling shares before you borrow them. In essence, you're selling something that you don't have and doesn't exist, because you're creating these shares out of nowhere and going out and selling them on the open market. Then the rest of the trade plays out the same way. But if you don't have the shares to begin with, they don't really exist. 

The SEC put in a regulation in 2005, a couple of years before the financial crisis, called Regulation SHO. It basically adds more requirements on the short selling process, mostly on the broker side. They have to be sure they're procuring the shares. And the SEC started to crack down on naked short selling a little bit more while the financial crisis and the Great Recession were playing out.

I should also note that there's one exemption to naked short-selling where it's actually allowed to take place, which is for options market makers. Options market makers are allowed to naked short sell. Throughout the process of their primary role in the market, which is providing liquidity to the options market, they're taking on all sorts of options positions. Options positions are hugely risky. The risk associated with options positions is astronomical. 

So, in order for them to offset that risk, they have to take underlying positions in the underlying stocks as a way to manage their risk. It's called delta hedging, which we won't get too deep into. Basically, they're trying to hedge their own risk. Because they need to be making these trades very quickly, they don't have the time to go out and procure. They're actually allowed to naked short sell, just as a way to help them to do their job without taking on a massive amount of risk.

Certainly, sometimes this exemption can be abused by market participants, but I don't think it's as common as it was ten, say, years ago. But, it's certainly not a good thing. It's not something people should be doing. And most people can't do it to begin with because the brokers have much more stringent controls in place at this point. But, it's another interesting aspect of what's out there.

Lewis: For the purposes of the average investor, naked short selling is probably something they won't ever come around, right?

Niu: Right. If you're trading through your broker, your broker is already going to be following all the rules.

Lewis: This was a really fun show to do. I'm really glad that Kelly wrote in this question. It was cool to do an investing concept and a little bit of a philosophical discussion about shorting. Evan, I hope that you are not short Industry Focus. [laughs] 

Niu: Too bad we're not public! 

Lewis: Too bad we're not public! Things are going great, I think, at Industry Focus. Well, thank you for hopping on, Evan! 

Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or tweet us at @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Anne Henry for all the work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

Dylan Lewis has no position in any of the stocks mentioned. Evan Niu, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Bausch Health Companies. The Motley Fool has a disclosure policy.