Short Selling Basics: How It Works

Reviewed by Charles Potters

Short selling—also known as “shorting,” “selling short” or “going short”—refers to the sale of a security or financial instrument that the seller has borrowed. The short seller believes that the borrowed security’s price will decline, enabling it to be bought back at a lower price for a profit. The difference between the price at which the security was sold and the price at which it was purchased represents the short seller’s profit—or loss, as the case may be.

Key Takeaways

• Short selling entails taking a bearish position in the market, hoping to profit from a security whose price loses value.
• To sell short, the security must first be borrowed on margin and then sold in the market, to be bought back at a later date.
• While some critics have argued that selling short is unethical because it is a bet against growth, most economists now recognize it as an important piece of a liquid and efficient market.

Is Short Selling Ethical?

Short selling is perhaps one of the most misunderstood topics in the realm of investing. In fact, short sellers are often reviled as callous individuals out for financial gain at any cost, without regard for the companies and livelihoods destroyed in the short-selling process. Short sellers have been labeled by some critics as being unethical because they bet against the economy.

But short sellers enable the markets to function smoothly by providing liquidity, and they can serve as a restraining influence on investors’ over-exuberance.

Excessive optimism often drives stocks up to lofty levels, especially at market peaks—dotcoms and technology stocks in the late 1990s, for example, and on a lesser scale, commodity and energy stocks from 2003 to 2007. Short selling acts as a reality check that can eventually limit the rise of stocks being bid up to ridiculous levels during times of excessive exuberance.

While shorting is fundamentally risky since it goes against the long-term upward trend of the markets, it is especially perilous when markets are surging. Short sellers confronted with escalating losses in a relentless bull market are reminded of John Maynard Keynes’ famous adage: “The market can stay irrational longer than you can stay solvent.”

Although short selling attracts its share of unscrupulous operators who may resort to unethical tactics to drive down the price of a stock, this is not very different from stock touts who use rumors and hype in “pump-and-dump” schemes to drive up a stock. Short selling has arguably gained more respectability in recent years with the involvement of hedge funds, quant funds, and other institutional investors on the short side. The eruption of two global bear markets within the first decade of this millennium has also increased the willingness of investors to learn about short selling as a tool for hedging portfolio risk.

Short selling can provide some defense against financial fraud by exposing companies that have fraudulently attempted to inflate their performances. Short sellers often do their homework, thoroughly researching before adopting a short position. Such research often brings to light information not readily available elsewhere and certainly not commonly available from brokerage houses that prefer to issue buy rather than sell recommendations.

Important

Overall, short selling is simply another way for stock investors to seek profits.

The Mechanics of Selling Short

Let’s use a basic example to demonstrate the short-selling process.

For starters, you would need a margin account at a brokerage firm to short a stock. You would then have to fund this account with a certain amount of margin. The standard margin requirement is 150%, which means that you have to come up with 50% of the proceeds that would accrue to you from shorting a stock. So if you want to short sell 100 shares of a stock trading at $10, you have to put in $500 as margin in your account.

Let’s say you have opened a margin account and are now looking for a suitable short-selling candidate. You decide that Conundrum Co. (a fictional company) is poised for a substantial decline, and decide to short 100 shares at $50 per share.

Here is how the short-sale process works:

1. You place the short-sale order through your online brokerage account or financial advisor. Note that you have to declare the short sale as such because an undeclared short sale amounts to a violation of securities laws.
2. Your broker will attempt to borrow the shares from a number of sources, including the brokerage’s inventory, from the margin accounts of one of its clients, or from another broker-dealer. Regulation SHO from the Securities and Exchange Commission (SEC) requires a broker-dealer to have reasonable grounds to believe that the security can be borrowed before effecting a short sale in any security. This is known as the “locate” requirement.
3. Once the shares have been borrowed or “located” by the broker-dealer, they will be sold in the market and the proceeds deposited in your margin account.

Your margin account now has $7,500 in it: $5,000 from the short sale of 100 shares of Conundrum at $50, plus $2,500 (50% of $5,000) as your margin deposit.

Let’s say that after a month, Conundrum is trading at $40. You therefore buy back the 100 Conundrum shares that were sold short at $40, spending $4,000. Your gross profit, ignoring costs and commissions for simplicity, is therefore $1,000 ($5,000 – $4,000).

On the other hand, suppose Conundrum does not decline as you had expected but instead surges to $70. Your loss in this case is $2,000 ($5,000 – $7,000).

A short sale can be regarded as the mirror image of “going long,” or buying a stock. In the above example, the other side of your short sale transaction would have been taken by a buyer of Conundrum Co. Your short position of 100 shares in the company is offset by the buyer’s long position of 100 shares. The stock buyer, of course, has a risk-reward payoff that is the polar opposite of the short seller’s payoff. In the first scenario, while the short seller has a profit of $1,000 from a decline in the stock, the stock buyer has a loss of the same amount. In the second scenario, where the stock advances, the short seller has a loss of $2,000, which is equal to the gain recorded by the buyer.

Short Selling Example: GameStop

GameStop (GME), a retailer focused on video games and related merchandise, offers a good example of short selling, how it works, and the risks involved.

In 2020, GameStop’s stock was performing poorly, trading at $1 or $2 per share. At the time, there was significant short interest in GameStop because investors believed that the company would fall in value. Then, GameStop became part of the meme stock rally.

In August 2020, YouTube persona, Roaring Kitty posted a video explaining that the stock could rise in value by more than 1,000% thanks in part to the short interest. Later that year, investor Ryan Cohen purchased a greater than 10% stake in the company and joined the board. The stock rose on this news. Shares slowly rose in price before rapidly spiking in January 2021 to a high of more than $80.

The short squeeze then began in earnest. As the price of shares rose, people with short positions had to purchase shares to close the position and prevent additional losses. That led to increased demand for GameStop shares, driving the price even higher. This led to a self-reinforcing cycle of short sellers trying to close their positions by buying shares, boosting demand and leading to higher share prices.

This cycle seemed to repeat itself on May 13, 2024, when Roaring Kitty, who had been silent for years, posted on the social media platform X, causing GameStop and other meme stocks, such as theater chain AMC Entertainment (AMC), to surge.

GameStop had been trading at about $10 per share in April 2024. But amid a renewed frenzy, the company’s shares reached the highest price since 2021, opening at $64.83 on May 14. Meanwhile, GameStop short sellers lost over $2 billion on May 13 and May 14, according to the analytics firm Ortex Technologies.

Who Are Typical Short Sellers?

Hedge funds

Hedge funds are one of the most active entities involved in shorting activity. Most hedge funds try to hedge market risk by selling short stocks or sectors that they consider overvalued.

Hedgers

Not to be confused with hedge funds, hedging involves taking an offsetting position in a security in order to limit the risk exposure in the initial position. An investor who buys or sells options can use a delta hedge to offset their risk by holding long and short positions of the same underlying asset.

Individuals

Sophisticated investors are also involved in short selling, either to hedge market risk or simply for speculation. Speculators account for a significant share of short activity.

Day traders are another key segment of the short side. Short selling is ideal for short-term traders who have the wherewithal to keep a close eye on their trading positions, as well as the necessary experience to make quick trading decisions.

Regulations on Short Selling

Short selling was restricted by the “uptick rule” for almost 70 years in the United States. Implemented by the SEC in 1938, the rule required every short sale transaction to be entered into at a price that was higher than the previous traded price, or on an uptick. The rule was designed to prevent short sellers from exacerbating the downward momentum in a stock when it is already declining.

The uptick rule was repealed by the SEC in July 2007. A number of market experts believe this repeal contributed to the ferocious bear market and market volatility of 2008 to 2009. In 2010, the SEC adopted an “alternative uptick rule” that restricts short selling when a stock has dropped at least 10% in one day.

In 2004 and 2005, the SEC implemented Regulation SHO, which updated short-sale regulations that had been essentially unchanged since 1938. Regulation SHO specifically sought to curb naked short selling—in which the seller does not borrow or arrange to borrow the shorted security—by imposing “locate” and “close-out” requirements for short sales.

In October 2023, the SEC announced a new rule aimed at enhancing the transparency of short-selling practices for both regulators and the general public. Investment managers who hold large short positions are required to report those positions to the SEC—if the short position in a particular security is at least $10 million or 2.5% or more of the total shares outstanding on average during that month. An aggregated, anonymized version of that data will be disclosed to the public.

Risks and Rewards

Short selling involves a number of risks, including the following:

Skewed risk-reward payoff

Unlike a long position in a security, where the loss is limited to the amount invested in the security and the potential profit is boundless, a short sale carries the risk of infinite loss. Meanwhile, the maximum gain—which would occur if the stock drops to zero—is limited.

Shorting is expensive

Short selling involves a number of costs over and above trading commissions. A significant cost is associated with borrowing shares to short, in addition to the interest that is normally payable on a margin account. The short seller is also on the hook for dividend payments made by the stock that has been shorted.

Going against the grain

As noted earlier, short selling goes against the entrenched upward trend of the markets. Most investors and other market participants are long-only, creating natural momentum in one direction.

Timing is everything

The timing of the short sale is critical since initiating a short sale at the wrong time can be a recipe for disaster. Because short sales are conducted on margin, if the price goes up instead of down, you can quickly see losses as brokers require the sales to be repurchased at ever higher prices, creating a short squeeze.

Regulatory risks

Regulators occasionally impose bans on short sales because of market conditions; this may trigger a spike in the markets, forcing the short seller to cover positions at a big loss. Stocks that are heavily shorted also have a risk of “buy in,” which refers to the closing out of a short position by a broker-dealer if the stock is very hard to borrow and its lenders are demanding it back.

Strict trading discipline required

The plethora of risks associated with short selling means that it is only suitable for traders and investors who have the trading discipline required to cut their losses when required. Holding an unprofitable short position in the hope that it will come back is not a viable strategy. Short selling requires constant position monitoring and adherence to tight stop losses.

Risks

• Requires constant monitoring and strict trading discipline

• Unforeseen regulatory bans can cause significant losses and, even without bans, losses can be immense and fast

• Short selling can incur expensive costs and requires timing capabilities

Rewards

• Short selling offers profit potential by capitalizing on market downturns, counterbalancing the usual long-only momentum

• Potential benefits from anticyclical behavior

• While short selling entails substantial risk, it also presents opportunities for significant returns

Why Do Investors Generally Short Sell?

Investors short sell to profit from a decline in a security’s price. This strategy allows them to earn money during a market downturn.

Can Any Security Be Shorted?

Not all securities can be shorted. Certain stocks may be designated as “hard to borrow” due to a lack of supply, regulatory restrictions, or the unwillingness of brokerage firms to lend out the securities.

What Is a Short Squeeze?

A short squeeze happens when a stock’s price rises sharply, causing short sellers to buy it in order to forestall even larger losses. Their scramble to buy only adds to the upward pressure on the stock’s price.

Can You Short Sell ETFs?

Yes, most exchange-traded funds (ETFs) can be shorted like regular stocks. However, because ETFs represent baskets of stocks, they may be less volatile than individual stocks, which could reduce potential profits from short selling.

The Bottom Line

Given these risks, why bother to short? Because stocks and markets often decline much faster than they rise and some over-valued securities can be profit opportunities.

For example, the S&P 500 doubled over a five-year period from 2002 to 2007, but then plunged 55% in less than 18 months, from October 2007 to March 2009. Astute investors who were short the market during this plunge made windfall profits from their short positions.

Short selling is, nonetheless, a relatively advanced strategy best suited for sophisticated investors or traders who are familiar with the risks of shorting and the regulations involved. The average investor may be better served by using put options to hedge downside risk or to speculate on a decline because of the limited risk involved. But for those who know how to use it effectively, short selling can be a potent weapon in one’s investing arsenal.

Read the original article on Investopedia.