Myth #7: Short selling increases market volatility

In 2008, banking top executives were contemplating the abyss from the parapet of their corner offices. The banking lobby promptly marched up to Washington to demand a moratorium on short selling. In response, the U.S. Securities and Exchange Commission (SEC) put a temporary ban on short selling in the country in an effort to "restore equilibrium to the markets." This was lifted a short time later. Once the dust had settled, some analysis was done on the effect of the short selling ban, and the Federal Reserve published a report in which they concluded that short selling actually reduces volatility.

In the boxing ring called the stock market, it is not every day that the U.S. Federal Reserve is in the corner of short sellers. Without further ado, see the opening paragraph of their report:

"In response to the sharp decline in prices of financial stocks in the fall of 2008, regulators in a number of countries banned short selling of particular stocks and industries. Evidence suggests that these bans did little to stop the slide in stock prices, but significantly increased costs of liquidity. In August 2011, the U.S. market experienced a large decline when Standard and Poor's announced a downgrade of U.S. debt. Our cross-sectional tests suggest that the decline in stock prices was not significantly driven or amplified by short selling. Short selling does not appear to be the root cause of recent stock market declines. Furthermore, banning short selling does not appear to prevent stock prices from falling when firm-specific or economy-wide economic fundamentals are weak, and may impose high costs on market participants."

Market participants sell short for various reasons. Options traders, convertible managers, and indexers need to delta-hedge their positions. The inability to sell short reduces liquidity and the offering of financial products. Restrictions on short selling are therefore a sign of market immaturity.