Pros and Cons of Short Selling vs Auction: Stocks

Buying stocks through short selling or investment requires careful planning and consideration. When considering purchasing stocks, do your homework. Consult an investment advisor. Calculate how much you are willing to invest.

Before discussing the pros and cons of short selling versus auction, here are some basic terms. A stock is a “piece” of the company. Each share of stock represents a small piece of ownership in a company. So, if you own shares, you will profit from any gains made by the company or dividends.

Stocks can be one of two types: (1) preferred stocks, which pay regular dividends or (2) common stocks, which represent ownership of the company and may offer more rights and privileges than preferred stock. Why issue stock? Businesses issue stock to raise money to finance operations, fund expansions, or pay for research and development. Methods for buying stock include short selling and auction.

What Is Short Selling?

Short selling is the sale of a security not owned by the seller. A practice, which has been hotly debated, short selling is now considered to be an essential feature of the securities market. Critics see short selling, whether done directly or indirectly, as posing potential risks. These risks can cause a destabilization of the market.

While short selling can increase the risk of market falls and manipulate activities, it can contribute to market liquidity. But, short selling is not illegal, in fact it is seen as beneficial to the market.

In a short sale, the buyer borrows assets from a third party, usually a broker, with the intention of buying identical assets at a later date. The benefits to the seller are that the she hopes to make a profit on any decline in the price of assets between the sale and the repurchase. Of course, if the assets rise in price, the short seller will lose money. Wikipedia uses the example a person borrowing $10, but returning a different $10 to the lender after the sale. To put it another way if a car is borrowed, the same car would have to be returned.

What Is a Stock Auction?

Although not as well-known as traditional auctions where goods are bought by the highest bidder, investment auctions are of economic importance to the business community. At auctions, buyers enter competitive bids for stocks. Each stock is traded at the highest price a buyer is willing to pay, which is the lowest price a seller is willing to sell. Bids from buyer and seller are paired together for compatibility. If a seller is not comfortable with the buyer’s offer, he can withdraw the stock.

The New York Stock Exchange is an example of a huge electronic auction. People bid on shares where the price of the share is constantly changing based on market forces. Buyers and sellers communicate with a central stock market, which matches buyers and sellers to each other.

The demand for a particular stock can increase or decrease depending on market forces.

Short Selling v. Auction

A short seller can potentially gain from the decline in price. The short seller must predict the market declines and upswings before buying short. What are the benefits of short selling?

  • Seller can benefit from fall of stock price.
  • Seller can sell stock. Earn invest income from cash invested from sale.

An alternative to short selling is the investment auction. An innovative auction process per Wikipedia was pioneered by investment bank WR Hambrect & Co. for distributing stock in an initial public offering. OpenIPO is a form of Dutch auction where shares of an initial public offering can be allocated in an impartial way with all successful bidders paying the same price per share.

According to Wikipedia, in a Dutch auction, unlike traditional auctions, the auctioneer begins with a high asking price which is lowered until someone accepts it. Based on a mathematical model, the OpenIPO auction treats all qualifying bids impartially, similar to the method for auctioning Treasury bills. The most notable company that WR Hambrecht used the OpenIPO auction on was Google in 2004.

The risks of short selling include that stock once purchased can be recalled and there is no limit to rate stock can rise. In an investment auction, the purchase price depends on what bids are accepted. Stocks sold at auction may be overpriced.

Investors looking to buy a short sale should thoroughly research options. Look at stock prices for increases/decreases, changes to accounting policies, or insider selling. Examples of good short sales for purchasing stock in businesses with:

  • a poor business model
  • high debt loads
  • deteriorating fundamentals
  • decreased down results
  • valuations with room for downturns
  • accounting issues
  • questionable management and practices

For an important resource for further information on investing, go to the Securities and Exchange Commission’s Office of Investor Education and Advocacy.