Short Selling: How It Works

The stock market isn't just about buying low and selling high. For some investors, it's about selling high and buying low—a strategy known as short selling, shorting, selling short, or going short. The sometimes controversial practice allows traders to profit from a stock's decline, but it comes with significant risks with the potential for big gains and devastating losses. It's thus only to be done by experienced investors.

Shorting involves borrowing a security, selling it on the open market, and then repurchasing it later at a lower price to return to the lender. Essentially, a short seller is betting that the security price will go down.

However, short selling is not for the faint of heart. It requires a deep understanding of market mechanics, careful risk management, and the ability to withstand potentially unlimited losses if a trade goes wrong. The GameStop saga of 2021 demonstrated how short sellers can get caught in a "squeeze," leading to massive losses when a heavily shorted stock suddenly skyrockets in price. It's proven essential to understand not just for those practicing it but for other market participants, too.

What Is Short Selling?

In recent years, short selling has been the focus of increased attention and controversy. One of the best-known events on Wall Street this decade was the GameStop short squeeze in early 2021, when a large group of retail investors, communicating primarily via the social media platform Reddit, drove the price of the heavily shorted stock up drastically. This resulted in significant losses for some hedge funds with large short positions. The event led to greater scrutiny of short selling practices by regulators and showed how social media-driven collective action among retail investors can disrupt traditional market dynamics.

Short selling is a strategy where traders profit from a decline in the price of an asset, often a stock. In a short sale, investors borrow shares of a stock they believe will fall in value, sell those shares on the open market, and later buy them back at a lower price to return to the lender. The difference between the sale and buyback price is the profit. However, if the stock price rises, the losses can be substantial, and there is no limit to how high a stock price can go. This makes short selling a high-risk strategy compared with simply buying shares and waiting for their value to rise.

The process begins with investors borrowing the stock from their brokers, which often involves paying interest. After the shares are sold, the investor must eventually repurchase them to close the short position. In this type of trade, time is a key element since the longer a short sale is out, the higher the interest costs and the longer it's been since the trading context gave rise to the trade.

How To Short Stocks

Short selling might seem counterintuitive at first glance, but understanding its mechanics is crucial for any investor given that short selling impacts everyone investing. Here's how you would typically go about it (if you were starting from scratch):

1. Open a Margin Account

To short sell, you'll need a margin account with a brokerage firm. This allows you to borrow securities and requires you to maintain a certain level of collateral, usually 150% of the short position's value. The standard margin requirement is 150%, which means that you have to come up with 50% of the proceeds that would accrue from shorting a stock.

2. Identify Your Target

Let’s say you have opened a margin account and are now looking for a suitable short-selling candidate. You'll need to choose a stock you believe is overvalued and likely to decline in price. This involves extensive research and analysis.

You decide that ShortMe Co. (a fictional company) is poised for a steep decline and decide to short 200 shares at $50 per share. Since you want to short sell $10,000 worth of shares, you have to deposit $5,000 as margin in your account.

3. Borrow the Shares

Your broker will locate shares of the target stock to borrow, typically from other investors' accounts or the brokerage's own inventory. The U.S. Securities and Exchange Commission's (SEC) Regulation SHO requires broker-dealers 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.

4. Sell the Borrowed Shares

Once the shares are borrowed, they're sold at the market price. The proceeds are deposited into your margin account.

Your margin account now has $15,000 in it: $10,000 from the short sale of 200 shares of ShortMe at $50, plus $5,000 (50% of $10,000) as your margin deposit.

5. Wait and Monitor

You'll closely watch the stock's price. If it declines as you predicted, you're in a profitable position. If it rises, you'll face losses.

Let’s say that after a month, ShortMe is trading at $40. You decide to buy back the 200 shares that were sold short, spending $8,000 or $40 per share.

6. Close the Position

To close a short position, you buy back the same number of shares you initially borrowed and return them to the lender. If the stock price has fallen, you'll profit from the difference between your initial sale price and the lower repurchase price.

Having bought back the shares you borrowed, your gross profit, ignoring fees and commissions for simplicity's sake, is $2,000 ($10,000 - $8,000 = $1,000).

When Short Selling Goes Very, Very Wrong

Suppose the scenario above didn't end so well. This happens when the price of the stock you are shorting rises instead of falling as anticipated.

For example, suppose that after you short 200 shares of ShortMe Co. at $50 per share, news breaks that the company has secured a lucrative new contract, and the stock price jumps to $70 per share. To close your position, you now need to buy back the 200 shares at $70 each, costing $14,000. Since you initially sold the shares for $10,000, your loss is $4,000, not including any fees or interest accrued during the short position.

Margin Call

Let's say, though, that you thought ShortMe's new contract wasn't enough for the company to dig itself out from recent financial problems, and the stock price should come back down as soon as other investors realize that. But the market is not always so rational, and the situation worsens. The stock continues its climb, reaching $100 per share.

You've now blown past your margin of $5,000 with your broker, who now issues a margin call since what's in your account can no longer cover your mounting losses. You face depositing additional funds to meet the margin requirement. If you close the position at $100 per share, you'll have to buy back the 200 shares for $20,000. Since you originally sold the shares for $10,000, your loss has ballooned to $10,000.

The margin call is a critical turning point. If you don't provide the required funds, your broker may automatically close your position to limit further risk, often at an unfavorable price. This forced liquidation can be devastating, as the stock price may continue to rise while your broker attempts to exit the position, leading to even bigger losses.

Short Selling Example: GameStop

But it's not just individual traders who can be devastated by short selling losses. GameStop (GME), a retailer focused on video games and related merchandise, offers an excellent example of short selling, how it works, and the risks involved for those not directly involved in trading a particular security.

In 2020, GameStop's stock was performing poorly, priced at less than $2 per share. At the time, there was significant short interest in GameStop because investors believed the company would fall still more 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 bought a further 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.

As you can see above, the short squeeze then began in earnest in January 2021. As the share price rose, those with short positions had to buy shares to close the position and prevent additional losses. That 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 even higher share prices.

The Regulatory Aftermath

The ballooning of a fundamentally problematic stock to such prices while causing massive losses suggested grave vulnerabilities in the financial system. There were Congressional hearings, and the SEC began reviewing trading practices and transparency in short-selling activities. Meanwhile, brokerage firms reassessed their risk management strategies after some, like Robinhood Markets Inc. (HOOD), controversially restricted trading because of liquidity concerns.

The event also spurred broader debates on market manipulation, the influence of social media on stock prices, and the responsibilities of retail trading platforms to their users. But to understand these recent changes, it's important to quickly revisit some of the history of the SEC's role in regulating short selling.

History of Short Selling Regulations

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 at a price 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.

Beginning in 2004, 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 doesn't borrow or arrange to borrow the shorted security—by imposing "locate" and "closeout" requirements for short sales.

Meanwhile, in 2007, the SEC repealed the uptick rule was repealed, though the SEC reversed itself in part in 2010. That year, the SEC adopted an "alternative uptick rule" that restricts short selling when a stock has dropped at least 10% in a day.

After the meme stock phenomenon earlier in the decade, in October 2023, the SEC adopted new rules to increase transparency in short-selling activities, requiring large institutional investors to report short positions in a particular equity security that are either $10 million or more or represent 2.5% or more of the total shares outstanding on average during a month.

The SEC, working with the Financial Industry Regulatory Authority, now publishes aggregated, anonymized data about these large short positions within four weeks after each month's end.

"It's important for the Commission and the public to know more about short sale activity in the equity markets, especially in times of stress or volatility," said SEC Chair Gary Gensler. The "adoption will promote greater transparency about short selling, both to regulators and the public."

The new rules also amended the National Market System Plan governing the Consolidated Audit Trail (CAT) so that each CAT reporting firm—those that are obligated to report data to the CAT regarding their trades—must indicate when they are using the bona fide market-making exception under Regulation SHO.

A market maker, typically a brokerage or financial firm, would need the market-making exception to help provide market liquidity by continuously buying and selling stocks to meet investor demand. This exception allows them to short-sell without first locating shares to borrow (what might otherwise be a naked short sale), which helps them quickly respond to buying and selling pressures, ensuring smoother market operations and minimizing disruptions to trading.

The exception, though, is only for when the short selling supports liquidity in the market. By mandating firms disclose when they use this exception, the SEC aims to ensure regulators have a clearer view of when and why firms use this flexibility.

Not all are on board with the changes, including Mark T. Uyeda, an SEC commissioner who has often been critical of the SEC's actions in recent years. His critique gets at a significant point proponents of short selling make about the practice, namely that short selling is central to price discovery and market efficiency.

"Short sales can play a vitally important role in setting a fair price for securities, which is perhaps the greatest protection for investors in the market," he said. Uyeda also raised concerns about the rule's potential to reveal short sellers' research and trading strategies, increase compliance costs, and expose managers to cybersecurity risks. These factors, he warned, could ultimately harm price efficiency by making short selling more costly and risky.

Still, GameStop Returns

Yet, that was still not the end of the GameStop fiasco. The cycle repeated in May 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 their 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.

Who Are the Typical Short Sellers?

Hedge Funds

Hedge funds are one of the most active short sellers. Many employ long-short strategies, balancing long positions with short positions in stocks or sectors they consider overvalued. This approach aims to generate returns, regardless of the overall market direction, and hedge against market risk.

Hedge funds were the target of the 2021 and 2024 GameStop short squeezes.

Hedgers

Not to be confused with hedge funds, hedging involves taking an offsetting position in a security 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

While less common due to the risks involved, some sophisticated individual investors engage in short selling. The rise of online brokerages has made short selling more accessible, though it remains a high-risk strategy for retail investors.

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

Institutional Investors

While less common, some traditional institutional investors like mutual funds and pension funds may engage in short selling as part of their risk management or alpha-generating strategies (those that accelerate profits). They typically use shorts to hedge long positions or make tactical bets against specific companies or sectors.

Market Makers and High-Frequency Traders

These participants often engage in short selling as part of their market-making activities, providing liquidity and profiting from small price discrepancies. Their short positions are typically held for very short periods.

How Activist Short Sellers Work

Given their prominence in the past decade, it's worth dedicating more space to how activist short sellers work. These are individuals or firms that take short positions and then publicly share their research, often alleging fraud or severe overvaluation. Their goal is to profit from the resulting price decline.

The Hunters of Wall Street

Activist short sellers act as self-appointed watchdogs exposing corporate fraud or overvaluation. These investors take short positions in companies they believe are overrated or engaged in questionable practices, then publicly share their research to drive down the stock price.

Notable examples include the aptly named Muddy Waters Research. Founded by Carson Block, the firm is known for uncovering fraud in Chinese companies listed on North American exchanges. One of its successes was identifying the fabrication of revenues at Luckin Coffee, a Chinese company that had claimed to be larger than Starbucks (SBUX). By exposing the fraud, Muddy Waters brought the company’s stock price crashing down. (The company has since again claimed to outpace Starbucks in revenue, reporting it finished the 4th quarter of 2023 about 20% of Starbucks China's revenues in 2023)

In what has become a consistent theme in this area of finance, however, Block has also been the target of SEC investigations looking into whether he misled investors for profit. (He hasn't been charged.)

Scorpion Capital, another activist short seller, has exposed overvalued biotechnology firms through in-depth due diligence.

In 2020, Hindenburg Research—another firm with a knack for names—gained wide attention for its report on Nikola Corporation, which led to a significant drop in the company's stock price and the resignation of its founder. Hindenburg Research became even more well-known for its investigation into the Adani Group, a prominent Indian conglomerate owned by Gautam Adani, who was then the world's third richest man. In essence, Hindenburg claimed that Adani was running a roughshod family business with debts piling high and stock prices for companies he owned inflated by over 800% due to market manipulation and accounting fraud. Almost immediately, about $100 billion in the stock value of the Adani Group was gone.

These cases highlight the pros of activist short selling:

• It can expose fraudulent activities that regulators might miss
• Provides a counterbalance to overly optimistic market sentiment
• Enhances market efficiency by encouraging more thorough analysis
  

Activist Investors: From Predator to Prey

Short sellers are nevertheless accused of spreading exaggerated negative information, including false rumors or unsubstantiated concerns. This can be done anonymously online, harming the company’s reputation and causing its stock price to fall below its true value. This tactic, known as “short and distort,” is a form of market manipulation that's the inverse of the old “pump and dump” scheme. In a pump and dump, an investor buys a stock, spreads false positive information to drive up its price, and then sells at the inflated value. Likewise, an activist short seller might spread false negative news after shorting a stock.

If a short seller has a reputation for accurately identifying overvalued companies, their statements can significantly affect a company's stock and prospects. But should market manipulation be involved, it's the short seller that will become the target.

For example, Andrew Left of Citron Research is known for his 2015 expose of Valeant Pharmaceuticals, which led to the company's downfall. However, by 2024, Left was facing fraud charges, with the SEC alleging Left used his Citron Research website and social media platforms to publish false and misleading stock recommendations on at least 23 companies.

According to the SEC, Left would publicly recommend long or short positions, causing significant stock price movements averaging over 12%. He would then quickly reverse his own stock positions to profit from these price changes, contrary to what he had told his followers. This "bait-and-switch" tactic allegedly netted Left and his firm $20 million.

"Andrew Left took advantage of his readers," said Kate Zoladz, director of the SEC's Los Angeles Regional Office. "He built their trust and induced them to trade on false pretenses so that he could quickly reverse direction and profit from the price moves following his reports."

Thus, critics of activist short selling aren't just the companies it targets. They argue it's too often the cause of the following:

• There's always the potential for market manipulation through false or exaggerated claims
• Can cause significant damage to targeted companies, even if allegations are unfounded
• There's an inherent conflict of interest since short sellers profit from a company's decline they help bring about.

Risks and Rewards of Short Selling

Short selling involves major risks, including the following:

Unbalanced Risk-Reward Profile

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 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

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 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.

The Bottom Line

Short selling remains a controversial yet implacable part of financial markets, serving as a risk management tool, not just for speculating on a company's downfall. While it can expose corporate fraud and market inefficiencies, recent regulatory actions and high-profile cases highlight the fine line between legitimate short-selling practices and potential market manipulation. The SEC's new transparency rules aim to strike a balance, providing regulators and the public with more information about short selling activities without overly restricting the practice. Those rules are the target of lawsuits.

As markets continue to evolve, the role of short sellers—from hedge funds to activist investors—will likely face ongoing scrutiny and debate. The challenges of regulating this complex area of finance are evident, with authorities striving to maintain market integrity while preserving the benefits that short selling can bring. For investors, understanding how short selling works, including its risks and the various players involved, is crucial in navigating today's financial markets.