Reference no: EM133377488

Question: During the Great Depression in 1929 when the market crashed, Jesse Livermore actually collected about $100 million by shorting stocks (Investopedia). Short selling became controversial as a result because he benefited off of the loss of companies. After this incident, the US government restricted short selling and enacted the Uptick Rule in 1938, which stated that "investors cannot short a stock unless the last trade was at a higher price than the previous trade" (Investopedia). The purpose of this rule, according to Investopedia, was to slow the momentum of a stock's decline and restore equilibrium in the market. Especially when the market is volatile, short selling can further increase downward pressure on stocks. Ultimately, these regulations over short selling were enacted because investors can contribute to market instability by spreading negative rumors to manipulate the market. Short selling can cause price declines in certain securities that are unrelated to the company's actual valuation.

However, banning short selling may not even work to restore market equilibrium, as noted in the New York Fed article, where after the short selling ban in 2008, the prices still fell over two weeks when the ban was in effect. The prices of the stocks stabilized after the ban was lifted. Banning short selling doesn't prevent stock prices from falling, especially if the company's underlying economic fundamentals are weak. Under normal market conditions, short selling can be useful because it can add liquidity to the market. Additionally, short selling is a useful tool for investors in order to hedge against a falling stock, especially if it is overvalued (WSJ).