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The following article is about Spanish government and other European markets' implementation of short-selling bans, my own explanations of why short-selling bans will not work and why short-sale bans will even backfire.
Most people often hear of the Big Hands and Insiders proclaiming that short-sale bans are ineffective market interventions and such mechanisms may even distort the market. The media merely repeats them without any explanations as they do not know the exact reasons too, except that the insiders said so.
Explanation Part 1:
Those who implement short-selling bans may be too naive to think that short-sale bans will limit supply and jack up demand, or at least that by limiting supply and ceteris paribus, prices will go up or remain more stable. It is gullible, or even naive, to assume that this theoretical mechanism in the Economics of Demand and Supply in a Perfectly Competitive system will work.
In a system of market, when there is no more short-selling, there will be no more short squeezes to push up the market (e.g. the Spanish market after they implement it), hence there will be effectively no incentive to collect opportunistic or counter-trend trading-longs to kill shortists and profit when markets get oversold (note: trading longs is DIFFERENT from investment longs); when there are no shorts to squeeze during a counter-trend wave in an outright bear market due to banned shorting, the rebound will be weak or very short-lived. This is because there will be no one who will be forced to buy high (demand at higher prices) and thereby providing a stablised and normal market mechanisms for unloading if someone (investors, traders, funds) wishes to get out at reasonable prices in prevailing market conditions.
No big hands, market makers nor anyone sound and logical would bother then to long/buy anything in a fundamentally-bad cum short-sale banned market. This is especially so when fundamentals are obviously awful or with even no fundamentals to speak of, except to long/buy merely for opportunistic rebounds to wipe out weak shortists or late shortists, thereby providing the all important demand.
Essentially, one can see that short-sale ban does a lot of potential harm in the market mechanisms by removing the demand layer when markets get oversold, rather than the cliche of inducing more supply in the economics side. The exit door, hence, gets narrower and narrower since the buy queues will thin out due to the lack of stimulus for counter-trend waves. The fibonacci ratios which are a natural law of life will then get distorted and not realised.
This "narrow door" further exacerbates when everyone wants to rush out, and because there will be no counter-trend long/buy-queues there waiting in anticipation to absorb sellings in a market that bans short-sellings, this effectively worsens the whole situation especially when bad or scaremongering news further inundate the market.
Often, short-selling bans are the final cat out of the bag of a serious bear market. This is because there are no more tools to use and policy-makers are desperate. It often serves to confirm that the cream has already turned sour. Sour creams can now only turn more sour. Essentially, short-sale bans are also often a prelude sign of a full-blown crisis.
Explanation Part 2:
On an extended induction to my explanations above, during a short-selling ban, because big long term investment funds think far ahead, they will get worried of the future high possibility of thinning-out buy queues, and may sell off first to avoid the future potential trouble of finding no counter-trend buyers. The selling on immediate term and short term may even be high due to "I better sell off and get out earlier than you do, because there will be no buyers there to catch falling knives to kill shorts anymore, especially when the fundamentals are so poor". In theory, banned short-selling is supposed to improve demand and reduce supply, but real life does the brutal opposite.
After the stage where long term investors attempt to get out on "short-sale ban knee-jerk rebounds", the long term Big Hand shortists also come in.
On surface, shorting in a short-sale banned market appears illogical. However, the real case is often the opposite. In this case, there is now an almost 100% sure case that the illogical action of shorting the short-sale banned market will definitely be a win. How? Knowing for sure that there will be no more demand at the buy/long queues to catch or support short-sale-banned market anymore (as per explained earlier), the big hands can now safely load put options, put warrants, any forms of fancy puts, shorts derivatives and those financial derivatives that give much higher-beta returns. These can be accumulated easily because most market participants think that Big Hands are not able to short anymore, markets are rebounding again and valuations are cheap.
The Big Boys (BBs) join in buying the large cap stocks and index stocks to help push up the stocks market of the short-sale banned market as they need these for their operations later. On the other hand, they do a set up on the opposite side over a period of time. They load up all the put options, put warrants, bearish CDS, fancy shorts and the shorts derivatives. For the index stocks they have on hand, they can easily sell and pour and dump at the future thinning buy/long walls (as explained earlier) that will break like tofu or wobbly jelly. Easy effort.
The deliberate loss made in selling the index stocks and big cap stocks is nothing compared to the high beta financial derivatives that are numerous folds in profits, which when leveraged is further magnified. All these index stocks and big caps stocks are just tools for the opposite high-beta derivatives, and the short-sale ban ironically facilitates the shorting process. When the time is ripe after accumulation, even though no shorts are allowed, BBs deliberately dump and pour out all these index stocks at a loss to plunge the market ("I have the stocks, so I am not shorting"); on the other hand, their derivatives spike up in profits, way larger from their losses made from index stocks and large cap stocks. On the way, panic retailers will help to contribute to the cause and hasten the process.
With no one there for a counter-trend shorts-slaying to push up stocks, there is a common understanding that if one tries to load up stocks in this short-sale banned lousy fundamentals market, one is almost sure to lose. Firstly, fundamentals are bad. Secondly, there is no more demand from shorts-killing traders, hence one is highly likely to suffer bad losses from stocks should one buy in this "supposedly demand-jacking and supply-limiting" short-sale-banned market.
The whole financial systems are a complex. Thinking in too simple terms or analysing in too simple ways is plain stupid, at times hastening one's death instead of preserving one's longevity.