COVID-19 has greatly damaged economies, and the stock market is not an exception. The drops have been so important, that several countries in Europe have forbidden the short positions. Is this really a good idea?
What is a short position?
A short position means that instead of buying to sell when the price rises, you sell to then buy when the price goes down. How is this possible? Easy, you just need to borrow the stocks from someone else. You borrow them, you sell them, and then when you buy the stocks to close the operation, you give them back to the original owner. Some brokers offer you this option. Another way is by using CFDs, but for that you need to know how leverage works very well. That is a topic for another post.
Thus, a short position sells, so the price falls. As a result, when something bad happens or there are bad expectations about the market, people short sell and try to benefit from price drops.
When a big crisis goes off like this one, investors usually claim to the financial authorities to forbid short positions. Does it make sense?
Well, the stock market is supposed to be a perfect market without these kinds of limitations. This kind of intervention proves that such a thing as a perfect market does not exist.
When people analyse the effects of short selling, they always forget the future. A short position means that someone must buy at some moment. It is true they can wait until the drop finishes, but even if that never happens, they will need to buy to close the operation and take the profits. In other words, a short-selling operation now will always imply buying later, and this will help the price to stop the losses. When you remove this option, there is not any motivation for buying a stock that is falling.
Moreover, if you are skeptic about market functioning, you may think like many others that big capitals usually move the stocks as they will. When minor investors run to the market to buy, who gives the liquidity? Is it other minor investors? Maybe some are, but usually it is big capitals. And it also happens otherwise. When a stock is falling too much, there is a point at which the big capitals have to enter to give liquidity to the market.
If minor investors would use short-selling, and more and more are doing it as time goes by, they are forcing the big capitals in the company to buy in order to stop their own losses.
Nowadays, short-selling is mainly used by professionals. We think minor investors should also take this option into consideration for their operatives. For that, it is highly recommended to get quality information about how it works, of course.
We are not saying anyone should short-sell now, but that anyone should know how it works to broaden their decision frame.