Why A Short-Selling Ban Is A Really Bad Idea

History is very clear about the unintended consequences for the market.

May 06, 2023

You’re reading the intro to the weekend edition of the Lund Loop newsletter.

It’s said that those who ignore history are doomed to repeat it.

But that hasn’t deterred a rising chorus of voices, who, in response to the recent sell off in regional banks, would like the SEC to revisit their failed 2008 experiment and institute a ban on short-selling.

To be fair, the SEC has said it is “not currently contemplating” a short-selling ban.

However, on Thursday, White House press secretary Karine Jean-Pierre noted that the Biden administration is closely monitoring market developments, “including the short-selling pressure on healthy banks.”

Heather Boushey, a member of President Biden’s Council of Economic Advisors, walked this statement back slightly on Friday, saying, “the information that we have at this point is that the situation remains under control,” but she went on to say that Biden hasn’t ruled out any options to ensure the stability of the banking system.

Let’s hope a ban on short-selling isn’t one of those options, because it’s a really bad idea, for a number of reasons.

First off, it doesn’t work. Second, it could literally break the market.

And we have history as a guide.

On September 19th, 2008, in the midst of the Financial Crisis, the SEC announced a short-selling ban on financial stocks.

Initially, the affected stocks rocketed higher - more on that in a minute - but as the gains were artificially induced, they were short-lived, reversing by the end of the day.

Then things got worse.

The chart above comes from an article published by the Federal Reserve Bank of New York, entitled, Market Declines: What Is Accomplished by Banning Short-Selling?

It clearly shows the answer to this likely rhetorical question is; bad things.

In fact, not only did financial stocks plummet over the following weeks, they actually underperformed the rest of the market.

Back in 2008, I was addicted to ice. Not the frozen blocks of water you put in your delicious and refreshing summer drinks, but the Intercontinental Exchange, ticker symbol ICE

I used to trade ICE like a crack addict, drawn into its crazy volatility.

September 18th was a Thursday, the Thursday before options expiration, and there had been some rumblings on CNBC about a short-selling ban.

The United Kingdom had enacted one on financial stocks the day before and I had a gut feeling that the same thing could happen in the US.

So I went to my go-to stock, ICE.

ICE was trading around $75.00 just before the close and I thought I would take a flyer and buy the closest OTM calls, which were the 80's.

Because there was less than 24-hours until expiration - and were $5.00 away from the strike price - they were trading for just fifty cents.

I bought 10 contracts, fully prepared to lose the whole five hundred if my hunch was wrong. I figured if I was right, I might be able to make a couple grand.

But as I mentioned above, after the market closed, the SEC banned short selling in 799 different financial stocks for three weeks.

ICE was one of those stocks.

The next morning I awoke to find financial stocks ripping higher in pre-market trading. Even though options don't trade pre-market, it looked like my "lotto ticket" calls could be worth some serious cash.

Once the market opened it got crazy. Dogs and cats living together crazy.

ICE opened at $87.84 and took off like a parabolic rocket. $90, $95...I was now $15K in the money.

Sweet. But things were just getting started.

$100, $105, $110, One-friggin'-fifteen. I was $35K in the money on a $500 investment. I'll take a 7000% return in 18 hours any day.

But something was wrong.

Very wrong.

The bid/ask on my calls had stopped at $13.30/$13.85.

This was not right. They should be worth at least $35K. I was owed over $21K.

“WTF is going on?” I thought.

I waited a bit, thinking maybe there was a data delay or a stuck quote, but the bid/ask didn't move. It just stayed there.

I defiantly stared at the screen, perturbed that the market wasn't giving me what I deserved.

Then suddenly, a voice in my head, that sounded very much like me, said, "close your position out right now."

I began to argue with myself.

No way I was going to sell. Sure, I would make an amazing profit, but there was no way I was going to leave 21K on the table.

Besides, ICE was at $135 and at the rate it was moving it might hit $140, $150, maybe even $160.

"Sell your calls. SELL THEM NOW," my inner dialogue screamed at me.

I hesitated for just a moment more, but something inside me instinctually knew this was the right move. I hit the bid and was filled.

The markets began to calm down and most of the high-flying stocks came back to earth. ICE ended up closing the day at $86.61, a little over six bucks in the money.

That night I found out why my calls never traded higher than the price at which I closed them.

The options specialist backed away and stopped making markets right after the open.

Why?

Without the ability to short stock, they couldn’t lay off the risk on their positions.

So the the market broke.

Short-sellers are convenient boogeymen, but all a ban does is reduce liquidity and create distortions in pricing. Even Chris Cox, the SEC chairman at the time of the 2008 ban, has acknowledged it was a bad idea.

And in the years since, there have been plenty of academic studies that confirm Cox’s conclusion.

Hopefully, this time regulators won’t ignore the lessons of history.

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It should go without saying - but I’ll say it anyway - all opinions expressed in The Lund Loop are my own personal opinions and don’t reflect the views of my employer, any associated entities, or other organizations I’m associated with.

Nothing written, expressed, or implied here should be looked at as investment advice or an admonition to buy, sell, or trade any security or financial instrument. As always, do your own diligence.

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