Short trading the market makes it go down. Right? Recent moves by several exchanges to reduce or eliminate short trading appear to support this conclusion. Well that would be wrong. This reveals a startling degree of illiteracy about financial markets.

No Shorts Please ...

• Pressure Builds for SEC to Extend Short Sell Ban
• The 'No-Short' List Becomes A Revolving Door
• Australia Eases Shorting Ban for Dual-Listed Stocks
• UK Slaps Ban on Short-Selling Financial Stocks
  

Let me make my position clear -- short selling is not behind the recent market selloffs. Rather, rotten company management, dishonest accounting practices, greedy margin borrowing secured against substantial company shareholdings, and misleading descriptions of debt ratings caused markets to fall. And they're still falling.

Let's debunk the myth that short selling causes the destruction of asset value, pushing the market lower. 

The market goes down, because long-side traders sell. They sell because they no longer have confidence in the ability of a company to deliver good returns. FEAR dominates the market. Very simply -- Falling Earnings And Returns -- FEAR.

The strategy of long-side traders is to buy low and sell high. They can sell their stock to other long-side traders. These are the optimists of a bear market who believe it will recover in the near future.

The long-side trader has to offer to sell at lower and lower prices until eventually he finds another long-side buyer. Long-side sellers simply sell, close their positions, take their losses and walk away from the market. They go to cash, and this drains liquidity from the market. Lastly, the other participants with money are the short-side traders. They borrow stock and sell.

There are four varieties of short-side trading.  In all four cases, the intention is to buy the stock back later, at a lower price, and return it to the stock lender.

Short-side traders hold an open position. They must become buyers again at some time in the future so that they can close their positions.

Unlike the long-side traders, they remain active in the market. In this sense, short-side traders create upward pressure because they must re-enter the market at some stage as buyers. They must close their positions to take either a profit or a loss. They will do this at multiple points during a market fall. This short 'covering' reduces the speed of a market fall and allows consolidation points to develop.

And here's where the myth develops.  It's perpetuated that short-side traders always get it right and make huge profits. The reality is, that short-side traders have about the same level of skill and success as long-side traders. They make mistakes and have to take losses. When they exit trades they buy and their trading activity in the market adds liquidity.

Let's look at three different markets to show the impact of short selling and its role in preventing market freefalls.

First, the Dow Jones Industrial Average.  It has the highest rate of short-side trading -- the market fall is 26 percent. Our second chart is Australia's S&P/ASX 200 Index. Here, it is more difficult to take short-side positions -- the market fall is 34 percent. Last but not least, is the Shanghai Composite Index, which allows no short selling. This leaves people with no alternative but to lose money in this market. The result is predictable. They will sell and be forced to sell at even lower prices because there are no buyers. Market liquidity will dry up. The Shanghai chart shows what happens -- the chart shows a whopping 70.5 percent fall.

There are those who will protest that China was an asset bubble, so the large fall is to be expected. However, similar bearish forces exist in all these markets. What else would you call the subprime and CDO mess if not an asset bubble? There is little doubt that in all three examples used, asset valuations were vastly removed from reality.  

Short selling adds liquidity and enhances the ability to manage risk through the use of hedging strategies. Hedging strategies are designed to protect portfolio value during adverse market movements.

Remove this ability, and the impact of a falling market is instantly multiplied because risk management is curtailed. Short selling provides liquidity and reduces the speed of a market decline because it gives skilled traders the opportunity to make money and provides market participants an alternative to simply losing money.

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