Bans on short-selling serve no purpose; so hug your shorts

As the markets are doing their boring routine, we could focus on an interesting study which reached a conclusion that active traders already knew about. The report concluded that temporary short-sale bans in bear markets do not help.

A short sale is a transaction where an investor borrows a stock to sell it with the intention of buying it back at a lower price. After the buyback the stock is returned to the lender.

So, for instance, an investor can short a stock at 10 and buy it back at seven and make a profit of three. Short sales are extremely popular for their quick profit potential, as markets fall much faster than they go up. Increasing interest by shortsellers in a rising market is often an indication of something rotten brewing.

[caption id=“attachment_414599” align=“alignleft” width=“380”] Banning short sales and ostracising shortsellers is the default action of politicians and regulators when the markets tank. Reuters[/caption]

Banning short sales and ostracising shortsellers is the default action of politicians and regulators when the markets tank. One will often hear the term “greedy speculators” from them and even some unsuccessful corporate managers when the self-correcting mechanism of the market punishes excesses.

Generally, market professionals would roll their eyes on seeing a short-sales witch-hunt begin and switch to trading futures and options to sidestep a short-selling ban.

It’s common wisdom that a market ready to tank will tank even if short sales are banned. Now, finally, we have official recognition about what market professionals already knew. The study will hopefully convince paper-pushing bureaucrats and retail investors of the futility of short-sale bans. May be some good will come out of it…like letting the markets be.

The study was conducted by Federal Reserve Bank of New York economist Hamid Mehran along with finance professors at the University of Notre Dame, Robert Battalio and Paul Schultz. The study, titled “Market Declines: What is accomplished by banning short selling?”, found that the 2008 ban on short sales in the US failed to slow the decline in the prices of financial stocks. In fact, prices fell markedly over the two weeks in which the ban was in effect and stabilised once it was lifted.

In another example, the study notes that following the downgrade of the US sovereign credit rating in 2011, stocks subject to short-selling restrictions performed worse than stocks free of such restraints. The authors point out that this issue is particularly important in the light of the latest wave of bans in Europe, including restrictions imposed by Spain and Italy in July.

So commonsense would say that a ban on short-selling should remove the selling pressure in the market and stop prices from dropping. But remember that the markets begin to fall not because shortsellers are selling but due to something bad coming to light. Shortsellers are selling because the stock is bad. To say that the main reason for prices to drop is because of short-selling and not because the stock is bad amounts to saying that wet streets cause rain. The cause always comes before the effect.

Now let me make a bold proclamation that short-selling eventually leads to price stabilisation and rallies. A shortseller is essentially a future buyer. Hence, when the shortseller covers his position, a falling market tends to stabilise or even rally. In the absence of shortsellers the number of future buyers is drastically reduced, cutting the demand for stocks. This actually leads to steeper drops in price with no corrections.

Short-covering often leads to corrective rallies. However, if a stock is a dud, no amount of covering can save it. Short-covering at least cushions the fall, which is absent if there is a ban on shorting. So if you don’t want the market to tank hug the shortsellers.

The ban on short -elling is not without risks. The study points out that bans seem to have the unwanted effect of raising trading costs, lowering market liquidity and preventing shortsellers from rooting out cases of fraud and earnings manipulation. The study concludes: “Thus, while shortsellers may bear bad news about companies’ prospects, they do not appear to be driving price declines in the market.”

Will the study change the minds of regulators? Of course not. Will it stop the witch-hunt of shortsellers by politicians and the general public? Nope. Retail investors are busy with their daily lives to pay too much attention to the workings of the market. The market works on the simple age-old theory of supply and demand. But what is simple is not always easy.

The regulator is a different animal who generally has no skin in the game. An investor loses money if he of she makes a mistake or if a regulator screws up. A regulator goes to a different posting whether he does well or not. So, dear readers, don’t expect much to come out of this report, but remember the lesson is that bans on short-sales do not stop price declines, but could accelerate them. Hence if you see a ban on shorting, don’t change your bearish bias.

George Albert is Editor, www.capturetrends.com