Short selling is an investment or trading strategy that speculates on the decline in a stock or other security’s price. Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one.
In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase them at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.
Here’s a practical example on how it works:
Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares.
A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale is $1,000: ($50 - $40 = $10 x 100 shares = $1,000).
However, if we change the above-described case to a scenario where XYZ stock reports great quarterly results and in reaction the stock rises to $60, the trader sits on a loss ($1,000: ($50 - $60 = $-10 x 100 shares = $-1,000). They then have two choices: Either, they close their position and walk away with the loss of $1000 or they try to extend their contract with the lender (if possible) in hopes of the stock rising again and them ultimately turning a profit. However, this can be very risky: Whereas the risk of loss in simply purchasing stock (“going long”) lies at a maximum of 100% of the invested capital (i.e. a stock cannot fall past a value of zero, so if you invest $1,000, you cannot lose more than $1,000), there is no limit as to how much a stock can rise in value. So, if a stock gathers momentum and keeps rising, the short seller can lose infinitely on their speculation.
In theory, a short seller can hold their short position until they cannot back it anymore financially. However, closing a position may be difficult if there are not enough shares to buy in the market. Especially if a stock is thinly traded, very sought after, or many short sellers are trying to close their positions at the same time, this may lead to a short squeeze spiral.
As a measure of transparency abiding by the Efficient Market Theory, the number of short positions on a company at any given point in time have to be made public and there are sites tracking the most shorted stocks.
A great quote on the information platform Investopedia states that “Most investment analysts agree that short selling is ethical.” In the market, short sellers are much loathed as they profit off of others’ failures and have the reputation to orchestrate market movements (dare one say manipulate(!) the markets?!) in so-called short attacks. However, following the Efficient Market Theory, they also serve an important function as they sniff out dysfunctional or even fraudulent companies, i.e. they detect inefficiencies in the market and thus help discovering a company’s fundamentally “true” stock price.