Why Banning Short Sales Screws Everyone

1) It leads to steeper declines

While it may seem counterintuitive, the people who are buying the most during market declines are people who sold the stock short and are buying it back to cover their positions. While shorts want stocks to go down, they become net buyers during declines because it represents an easy opportunity to book the profit out of a short position. The presence of these short buyers exerts a marginal pressure upwards on the stock price. Without these buyers (because they outlawed shorts on financials), longs who want to sell find less of a willing market to sell into. This means that there is less buy-side liquidity for any given market decline. Thus long sellers have to push the price down further to attract the same amount of buyers as before the ban.

2) It leads to steeper rises and worse buy prices

Normally when the market is presented with a bid that seems too high any participant can sell to that buyer (be it a long sale or short sale). With shorts banned only someone who is already long the stock can sell to this "too high" bid. This is by necessity a smaller number of people than before the ban. Thus for any given rise in price, there are less sellers attracted now than before the ban. Just as the absence of short buyers led to steeper declines and worse prices for sellers, the lack of short sales means that buyers have to push up the price higher to receive the same amount of stock as before the ban. This means that when you buy a financial during an upswing, you are paying more for it than you would if there were short sellers.

3) It causes dislocated prices

Markets are interconnected more than in any time in history. Computer based statistical arbitrage traders push stocks that have nothing to do with each other economically around as though they were competitors. These trades are based off of identifying and enforcing statistical correlations among large portfolios of stocks. A stat arb trader relies on being able to go both long and short at a moments notice. The ban on short sales has thrown a wrench in their trading systems, which leads to crazy price movements as the programs attempt to adjust to the new world order. This has led to extremely dislocated prices since last week: stocks will move points in seconds, effectively establishing two prices for a stock at once. While this has been a bonanza for traders like me, we must all realize that this severely hurts the systemic health of the system: who is going to want to invest when they get completely screwed (by multiple percent) on their price within a few seconds?

-RiskAffine

PS: while I am aware that banning shorts causes a certain marginal decrease in selling, as a trader I assume that most short selling is done on the way up and not used to pound stocks into oblivion. The only time a short seller can make a stock go down is if there are already an imbalance of long orders to the sell-side. A short seller who tries to single handedly push down a stock will get his face ripped off. Lets face it, shorts are sometimes the ONLY buyers of stock on the way down. They support the market on declines and regulate its exuberance on rips.