The case against allowing short sales

Why the physical short is bad.

The recent Gamestop short squeeze highlighted short selling. As I’ve explained here at slightly greater length, a short sale is basically selling an IOU note denominated in stock. After completing the short sale, the short seller holds some amount of cash and has the obligation to deliver a share of stock to another person at a particular point in time.

Standard explanation of a short. Emphasis added showing how the short seller has the same obligation whether or not the short is “naked.” Image remixed from 1 and 2. Original images by user Grochim on Wikimedia.

This is true both for “naked” short selling (theoretically illegal) and “covered” short selling (entirely legal). The difference with a “covered” short is that there is a small fee involved. This is sometimes known more precisely as a “physical short,” because there are other ways to have a “short” (pessimistic) position on a stock. The problem with this is that while the return from a short sale is private, the risk is socialized.

Profit / loss curve for a physical short sale. Own work.

The way a short seller makes a profit is that if the stock price drops before they’re required to deliver a share, they can meet their obligations by buying stock at a lower price than what they got from selling an IOU.

On the other hand, if the price of the stock increases, the short seller loses money…