Short Selling and Liquidity

Proponents of short selling repeat the theme that short selling improves liquidity.

All of my experience shows that the exact opposite happens. Short selling decreases liquidity.

Wikipedia (drawn 11/20/2010) defines "Market Liquidity" as "an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value."

My experience is that when a short seller has a large block on the ask line, it is difficult to sell the stock without accepting a steep loss. I've often seen the case where a piece of bad news hits a stock. The short interest in the stock will explode and the price will tank. This reduces the ability of the common share owners to liquidate their stock.

I have noticed that short interest tends to jump just before planned sales of stocks. For example, when employee stock options vest, there is generally a jump in short interest prior to the vesting date dramatically dropping the price during the window when employees are allowed to exercise their options with planned sales.

Short interest increases whenever a company plans a secondary offering. The short sales are decreasing the liquidity of the stock.

Short sellers are like other investors. They want to sell high and buy low. As such short selling generally increase during market dips.

There was a massive increase in short selling during the liquity crisis of 2008. The prime time to short stock is when people are panicking or otherwise being forced to sell.

Yes, back in the 1800s when it took several days to execute a transaction, short selling helped improve the liquidity of stocks.

But when one has a system where transactions can take place in real time, there are few cases when short selling actually improves liquidity.

The most active short selling occurs when there is a distressed seller. In these cases short selling dramatically decreases the ability of the distressed seller from selling their stock.