The Impact of Short Sale Restrictions

A short sale is an attempt to profit from a price decline in a financial asset or commodity by selling borrowed securities and buying them back at a lower price. Say a trader borrows 100 shares from a broker and sells them for $50 each on the stock market. If he buys them back at $45 per share, he’ll earn $500. Restrictions on short sales are controversial, and their impact is the subject of much study.

The U.S. Alternative Uptick Rule

The U.S. Securities and Exchange Commission has issued a rule to restrict short selling under certain circumstances. Under the alternative uptick rule, trading halts when the market price of a security declines 10 percent in one day. Once triggered, the rule remains in effect for the remainder of the trading day and all of the next trading day. The restriction does not allow a short sale to occur at a price equal to or less than the highest current nationwide offer to purchase the security. In this way, short sales cannot drive down prices without an intervening uptick in price.

Impact on Prices

The justification for short selling restrictions is to prevent a precipitous downward spiral in prices as traders continue to borrow and sell shares, overwhelming demand for the shares. However, a 2012 study measuring the effect of restricted shorting on asset prices, led by Professor Rodrigo De-Losso of the Department of Economics, University of Sao Paulo, found evidence that restrictions on the short selling of an asset led to overpricing of that asset and to greater confusion among traders about what the proper price should be. This result supports the theory that unrestricted short selling helps securities reach their “proper” level.

Impact on Volatility

Asymmetric volatility is a term applied to shares trading in the face of unexpected news. Many studies have shown that stocks fall faster on bad news than they rise on good news. A 2011 study assessing the impact of restricted shorting on stock volatility by Professor Shih Yung Wei, a researcher at the National Taiwan University of Science and Technology, presents evidence that short sale restrictions do tend to curb asymmetric volatility on smaller stocks but are counterproductive on large stocks; asymmetric volatility on these stocks actually increases. The study thus presents a mixed view of the impact of short sales restrictions -- favorable for small stocks but unfavorable for large ones.

Impact on Corporate Investment

A 2012 paper on the real effects of short selling by Professor Gustavo Grullon of Rice University suggests that the confusion over the “proper” price of shares operating under short sale restrictions causes smaller firms to delay corporate investments in new projects. Companies only approve projects in which the expected rate of return on the investment exceeds the cost of capital to finance the project. The cost of equity capital is the minimum return demanded by shareholders, and return is a function of current share prices. The dividend capitalization model states that required return is equal to the firm’s growth rate added to the quotient of dividends divided by share price. Since evidence suggests the short sale restrictions distort current share prices, corporate managers may feel uncertain about the cost of equity capital and thus postpone investment decisions.

Resources (3)

  • SEC Approves Short Selling Restrictions
  • "The New Sell and Sell Short: How to Take Profits, Cut Losses, and Benefit From Price Declines": Alexander Elder
  • "Foundations and Applications of the Time Value of Money (Frank J. Fabozzi Series)"; Pamela Peterson Drake, Frank J. Fabozzi

About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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