Thursday, September 21, 2017

Efficiently Inefficient #10 : Dedicated Short Bias

Reading the section on dedicated short bias made me want to join a hedge fund that does only short-only positions.

The personality of a typical short-seller is also rather interesting : It is usually someone who is antisocial, with a chip on his shoulder, and twisted sense of humour. Short sellers also don't agree with each other. Short sellers are also notorious frugal and successful traders do not adopt the trappings of a successful financial professional.

I have written other articles on short selling, so I will only illustrate in a novel way why short-sellers are often right about markets overestimating a stock price if short sellers face more frictions than investors who go long in stocks.

Short sale frictions means that companies are overvalued.

The example below illustrates how shutting off short-sellers can generate speculative bubbles.

Imagine that there are two types of investors :

  • Type A believe that a stock is worth 80 in a recession and 120 in a boom. Or 100 on average.
  • Type B believes that a stock is worth 60 in a recession and 140 in a boom.  Or 100 on average.

Note that in both cases, both investors believe that a stock is worth 100 on average.

If not shorting is allowed in this market :

  • In a recession, type A investors will be actively trading and will push the stock price to 80 because that's what the stock is worth in a recession. Type B investors can only suck thumb because they can't short the market even though they believe that the stock is worth on 60.
  • In a boom, type B investors will be actively trading and will push the stock price to 140 because that's what the stock is worth in a boom. Type A investors suck thumb because they can't short the market even though they believe that the stock is worth 120.

So in practice, the average price where there in equal probability of a boom and recession will cause the stock to be worth 110 or (80 + 140)/2. The result being that all investors are willing to pay up to 110 in spite of the stock being believed to only be worth 100.

At least from what little I know, speculative bubbles in Asia tend to come from real estate where no degree of shorting is even possible. Consequently, I expect statements of a bubble over cryptocurrencies may be overblown as exchanges do allow a high degree of shorting cryptocurrencies. Comparisons with Tulipmania is, therefore, unfair.






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