<p>In an ideal market buyers and sellers in aggregate incorporate all available information and, as a result, the market price of an asset reflects its fair value.</p>
<p>But in real securities markets there is an asymmetry in the ability of informed capital to participate:  If a market participant thinks that an asset is overpriced then he can sell the asset short.  But there is no way to take a short position on an asset that isn't exposed to the possibility of short-term &quot;ruin&quot; even if the seller is long-term &quot;correct&quot; about the mispricing.  Bullish investors can buy and hold an asset indefinitely.  But a bearish investor who sells short can exhaust his capital and get &quot;squeezed&quot; out of his position by a pop in price (which can occur due to liquidity demand and plenty of other non-information-based events).  Futures and options have the same possibility of ruining a bear based on shorter-term price paths.</p>
<p>Is there a term in the art that describes this situation in which <em>it's easy for capital to express positive sentiment but risky for capital to maintain a negative sentiment?</em></p>
<p>Are there theories or models that characterize expected and equilibrium prices given this asymmetry?</p>
<p>I.e., capital that thinks an asset is undervalued can buy it, so an asset should rarely spend time below its equilibrium value.  But capital that thinks an asset is similarly overvalued can only <em>not</em> buy it,* which doesn't put the same sort of pressure on the price as does buying it.  Based on this simplistic observation one would conclude that market inefficiencies should generally create excessively high prices.  But that's only meaningful to the extent that different market characteristics impose different barriers to short positions.  For example, an asset with higher implied volatility would have a higher chance of ruining a short seller, so high-volatility assets would be expected to be more overvalued.</p>
<hr />
<p><sup>* Yes, bearish capital can often sell short, but short selling has an added risk of &quot;ruin.&quot;  Even capital willing to bear that additional risk will add it to the perceived risk of exposure, and so the risk-adjusted mispricing required to attract capital to sell short is significantly higher than the risk-adjusted mispricing required to attract capital to buy.  I.e., capital will not actively act on an overvalued asset until the overpricing is far greater than the underpricing required to attract the same capital to act.  So there is an asymmetric incentive to express negative information.</sup></p>

CC BY-SA 4.0
2021-05-25T19:17:10.680Z
I'm a little confused - You can short or sell an asset if you think it's overvalued.  Gamestop is currently a hot topic, and many people are learning about shorting for the first time.
RegressForward
CC BY-SA 4.0
2021-05-25T19:25:34.850Z
@RegressForward If you sell short you have unlimited exposure to price increases that can exhaust the ability of any finite amount of capital to hold the position (this is known as a "short squeeze," and it is a very real and salient risk which prevents bears from actually taking a position based on their information).  If you buy the asset you can hold it indefinitely because your exposure is limited to the price paid to buy it.
feetwet
CC BY-SA 4.0
2021-05-25T19:35:54.747Z
The loss on a long position taken without margin is limited to 100%. The loss on a short position taken without margin (but I think all short sellers have to use a margin account) could be unlimited but if the market doubles in price then it would be a 100% loss to cover the position. However if one takes a long or short position with margin and it is subject to a margin call one can run out of capital by taking risk in either the long or short margin position. The leverage causes an amplified loss of capital when the market moves against the direction of the position.
SystemTheory
CC BY-SA 4.0
2021-05-25T19:38:23.010Z
@SystemTheory For purposes of price discovery questions I would assert that total market capital is unlevered – i.e., price discovery is driven by information.  Some capital might be levered, which can lead to short-term liquidity shocks, but we don't expect that to lead to information shocks.
feetwet
CC BY-SA 4.0
2021-05-25T19:50:31.833Z
@feetwet I think you have the making of a good question here, however, the long bias in the stock market is baked into the political-economic games that we call capitalism and democracy. The managers of corporations get stock incentives to make stock prices go up and tend to think like the long position stakeholders. The only thing that forces someone to take a loss on a position without margin is bankruptcy of the underlying company. A short position with no margin call could stay open forever at a paper loss as long as the trader has the guts to hold it until the price comes down.
SystemTheory
CC BY-SA 4.0
2021-05-25T19:52:54.443Z
@SystemTheory Yes this is more of a "market microstructure" question: I'm looking for theory or models that explicitly account for the fact that capital doesn't get to accumulate unlimited paper losses.
feetwet
CC BY-SA 4.0
2021-05-25T20:20:52.717Z
Efficient market hypothesis is a controversial theory. Some papers treat it as a falsifiable hypothesis and others argue it is not falsifiable. The main argument for index investing and/or dollar cost averaging strategies is that market prices follow a random walk so one cannot beat the overall market return in the long run. This is like a math expert saying you should surf the whole ocean. But surfers (traders) position their surfboards (limited capital) where they hope to catch and ride individual waves (price waves). Surfers kick out of bad waves (cut the ride short). Traders cut losses.
SystemTheory
CC BY-SA 4.0
2021-05-25T20:38:43.950Z
@SystemTheory I don't think this question requires an opinion on EMH.  The question only assumes that a security's market price incorporates beliefs (or information) from multiple participants who are disposed to contribute capital (long or short) when the market price is sufficiently far (in risk-adjusted terms) from what they believe to be the fair price.
feetwet
CC BY-SA 4.0
2021-05-25T22:55:33.913Z
You specifically describe an efficient market as one where investor incorporate all available information and the assumptions that prices reflect value under those conditions. I am fairly certain these are the assumptions underlying the efficient market hypothesis. The questions you are asking pertain to my first rule of investing: liquidity is scarce. If I want to sell in volume then someone else must be buying in volume. If I want to buy in volume then someone else must be willing to sell in volume. Price moves until the less liquid side provides volume so liquidity is caused by sentiment.
SystemTheory
CC BY-SA 4.0
2021-05-25T23:05:05.913Z
Let us [continue this discussion in chat](https://chat.stackexchange.com/rooms/124683/discussion-between-feetwet-and-systemtheory).
feetwet
CC BY-SA 4.0
2021-05-26T13:22:49.157Z
Hi: I'm not sure if they answer your question specifically but you may want to check out the paper by grossman and stigler in 1980. https://en.wikipedia.org/wiki/Grossman-Stiglitz_Paradox
mark leeds
<microeconomics><efficient-markets><market-failure>
Market efficiency given asymmetric characteristics of securities markets
feetwet
# Market efficiency given asymmetric characteristics of securities markets

(Asked by: username_0 on 2021-05-25)

In an ideal market buyers and sellers in aggregate incorporate all available information and, as a result, the market price of an asset reflects its fair value.

But in real securities markets there is an asymmetry in the ability of informed capital to participate: If a market participant thinks that an asset is overpriced then he can sell the asset short. But there is no way to take a short position on an asset that isn't exposed to the possibility of short-term "ruin" even if the seller is long-term "correct" about the mispricing. Bullish investors can buy and hold an asset indefinitely. But a bearish investor who sells short can exhaust his capital and get "squeezed" out of his position by a pop in price (which can occur due to liquidity demand and plenty of other non-information-based events). Futures and options have the same possibility of ruining a bear based on shorter-term price paths.

Is there a term in the art that describes this situation in which *it's easy for capital to express positive sentiment but risky for capital to maintain a negative sentiment?*

Are there theories or models that characterize expected and equilibrium prices given this asymmetry?

I.e., capital that thinks an asset is undervalued can buy it, so an asset should rarely spend time below its equilibrium value. But capital that thinks an asset is similarly overvalued can only *not* buy it,\* which doesn't put the same sort of pressure on the price as does buying it. Based on this simplistic observation one would conclude that market inefficiencies should generally create excessively high prices. But that's only meaningful to the extent that different market characteristics impose different barriers to short positions. For example, an asset with higher implied volatility would have a higher chance of ruining a short seller, so high-volatility assets would be expected to be more overvalued.

---

\* Yes, bearish capital can often sell short, but short selling has an added risk of "ruin." Even capital willing to bear that additional risk will add it to the perceived risk of exposure, and so the risk-adjusted mispricing required to attract capital to sell short is significantly higher than the risk-adjusted mispricing required to attract capital to buy. I.e., capital will not actively act on an overvalued asset until the overpricing is far greater than the underpricing required to attract the same capital to act. So there is an asymmetric incentive to express negative information.

**Tags:** microeconomics, efficient-markets, market-failure

> **Comments:**
> **username_1**: I'm a little confused - You can short or sell an asset if you think it's overvalued.  Gamestop is currently a hot topic, and many people are learning about shorting for the first time.  
> **username_0**: @username_1 If you sell short you have unlimited exposure to price increases that can exhaust the ability of any finite amount of capital to hold the position (this is known as a "short squeeze," and it is a very real and salient risk which prevents bears from actually taking a position based on their information).  If you buy the asset you can hold it indefinitely because your exposure is limited to the price paid to buy it.  
> **username_2**: The loss on a long position taken without margin is limited to 100%. The loss on a short position taken without margin (but I think all short sellers have to use a margin account) could be unlimited but if the market doubles in price then it would be a 100% loss to cover the position. However if one takes a long or short position with margin and it is subject to a margin call one can run out of capital by taking risk in either the long or short margin position. The leverage causes an amplified loss of capital when the market moves against the direction of the position.  
> **username_0**: @username_2 For purposes of price discovery questions I would assert that total market capital is unlevered – i.e., price discovery is driven by information.  Some capital might be levered, which can lead to short-term liquidity shocks, but we don't expect that to lead to information shocks.  
> **username_2**: @username_0 I think you have the making of a good question here, however, the long bias in the stock market is baked into the political-economic games that we call capitalism and democracy. The managers of corporations get stock incentives to make stock prices go up and tend to think like the long position stakeholders. The only thing that forces someone to take a loss on a position without margin is bankruptcy of the underlying company. A short position with no margin call could stay open forever at a paper loss as long as the trader has the guts to hold it until the price comes down.  
> **username_0**: @username_2 Yes this is more of a "market microstructure" question: I'm looking for theory or models that explicitly account for the fact that capital doesn't get to accumulate unlimited paper losses.  
> **username_2**: Efficient market hypothesis is a controversial theory. Some papers treat it as a falsifiable hypothesis and others argue it is not falsifiable. The main argument for index investing and/or dollar cost averaging strategies is that market prices follow a random walk so one cannot beat the overall market return in the long run. This is like a math expert saying you should surf the whole ocean. But surfers (traders) position their surfboards (limited capital) where they hope to catch and ride individual waves (price waves). Surfers kick out of bad waves (cut the ride short). Traders cut losses.  
> **username_0**: @username_2 I don't think this question requires an opinion on EMH.  The question only assumes that a security's market price incorporates beliefs (or information) from multiple participants who are disposed to contribute capital (long or short) when the market price is sufficiently far (in risk-adjusted terms) from what they believe to be the fair price.  
> **username_2**: You specifically describe an efficient market as one where investor incorporate all available information and the assumptions that prices reflect value under those conditions. I am fairly certain these are the assumptions underlying the efficient market hypothesis. The questions you are asking pertain to my first rule of investing: liquidity is scarce. If I want to sell in volume then someone else must be buying in volume. If I want to buy in volume then someone else must be willing to sell in volume. Price moves until the less liquid side provides volume so liquidity is caused by sentiment.  
> **username_0**: Let us [continue this discussion in chat](https://chat.stackexchange.com/rooms/124683/discussion-between-username_0-and-username_2).  
> **username_3**: Hi: I'm not sure if they answer your question specifically but you may want to check out the paper by grossman and stigler in 1980. https://en.wikipedia.org/wiki/Grossman-Stiglitz_Paradox  

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## 0 answers

