What is short selling? Investing Explained

In this series, we break down the jargon and explain a popular investment term or theme. Here’s going short.

What is it?

A trading strategy that aims to profit from the fall in the price of a share, bond, commodity, currency or stock market index. It’s risky, potentially lucrative. US short sellers are said to have lost $572 billion between 2019 and 2021, according to analysis group S3 Partners. But in 2022, they made profits of about $300 billion after betting that stocks like those of electric vehicle maker Tesla were about to tumble.

How does it work?

An investor convinced that a company’s stock is heading for a sharp decline borrows a block of those shares from an existing holder, such as a fund. The trader sells stocks, hoping they will fall. The next step is to buy them back later at a discounted price, to return to the owner. The profit is the difference between the price at which the shares were sold and the price at which they were bought back.

What can go wrong?

A lot. The direction of stock prices can confuse even the most seasoned investor. Technically, a short seller’s losses can be unlimited because in theory a stock can continue to rise and there is no cap on the amount you might have to pay to buy back the stock. When a stock price rises unexpectedly, short sellers can be caught off guard by what’s known as a bear squeeze.

Is it new?

It has been around since stock trading began in the 1600s in the Netherlands. It has been banned several times. ‘Naked’ short selling – shorting shares without borrowing them first – is illegal in the US and UK under rules adopted from the EU. The entire short selling regime will be changed as part of the Chancellor’s proposed reforms to Edinburgh’s financial services sector, which are currently under discussion.

Is short selling a bad thing?

Opinions differ. Some argue that short selling is an important part of an efficient stock market because it enables “price discovery”—revealing what a stock is really worth.

But short sellers are also accused of causing a price drop or exacerbating that drop, sometimes in defeat. It is also sometimes said that they benefit from adversity.

Which stocks are shorted?

The list of stocks, prepared by the Financial Conduct Authority, includes Asos, Kingfisher, Boohoo, Hammerson and Currys. Investors should consult this list regularly.

Why would a fund lend shares?

For the surcharges. According to S&P Global Market Intelligence, institutions worldwide earned $12.5 billion from these types of loans. During the pension crisis, fueled by last year’s mini budget, some investors shorted gold-edged government stocks as the prices of these bonds fell. Institutions that provided loans to these short sellers earned about $182.4 million.

Who are the big shorts?

Most famous is Michael Burry, founder of Scion Capital, whose bets on the US subprime housing market prior to the global financial crisis were chronicled in Michael Lewis’s The Big Short, which was later made into a movie. Anyone interested in Burry’s take on the scene today should follow him on Twitter (where he goes by the name Cassandra BC). Other players include Carson Block from Muddy waters Research.