Short Selling

Short selling, or shorting, is the sale of a security that the seller does not own, usually by borrowing it from another investor, with the aim of buying it back later at a lower price. The short seller returns the borrowed security to the lender, pays a borrowing fee, and keeps any difference between the sale price and the repurchase price. It is the main way investors express the view that a price will fall, and it creates a short position, the opposite of the long position held by an ordinary owner (see long and short positions).

Short selling is used by hedge funds, market makers, arbitrage traders and investors hedging other holdings. It depends on a securities-lending market in which pension funds, index funds and other long-term holders lend shares for a fee, usually through a prime broker. Similar bets on falling prices can be made with derivatives such as futures, put options and contracts for difference.

Imagine a friend lends you their concert ticket for a week. You believe the show will be a flop, so you sell the ticket today for $100. A few days later, as reviews come in badly, you buy an identical ticket for $60, hand it back to your friend with a small thank-you gift, and keep the $40 difference.

If the reviews are glowing instead, ticket prices might jump to $200, $300 or more, and you still have to buy one to return. There is no ceiling on how high the price can go, which is why a short seller's possible loss is, in principle, unlimited.

1. The investor arranges to borrow shares through a broker and sells them in the market.
2. The sale proceeds are held as collateral, and the investor posts extra margin, as in margin trading.
3. While the position is open, the short seller pays a borrowing fee and must compensate the lender for any dividends.
4. To close, the investor buys the shares back and returns them. The lender can recall the shares at any time, forcing an early close.

The profit or loss before costs is:

• $P_{\text{sell}}$ is the price at which the borrowed shares were sold.
• $P_{\text{buy}}$ is the price at which they were bought back.
• $n$ is the number of shares and $F$ the total borrowing fees.

Shorting 100 shares at $50, buying them back at $40 and paying $30 in fees gives $(50 - 40) \times 100 - 30 = 970$ dollars. If the price instead rose to $80, the loss would be $3{,}000 + 30$, or $3,030, and a margin call would likely force the investor to add cash along the way.

Supporters argue that short sellers add information and liquidity to the secondary market. They let pessimistic views enter prices, which aids price discovery and, under the efficient market hypothesis, makes prices more accurate. Short positions are used for hedging, for arbitrage between related securities, and by market makers who sell before they own. Research-driven "activist" short sellers have exposed accounting frauds, such as at Germany's Wirecard, which collapsed in 2020 after years of short-seller criticism.

Critics argue that short selling can deepen falls in a panic and that abusive tactics, such as spreading false rumours, amount to market manipulation. "Naked" short selling, selling shares without first borrowing or arranging to borrow them, can lead to failures to deliver and is restricted in most major markets.

A short squeeze happens when a rising price forces short sellers to buy back shares to limit losses, and their buying drives the price higher still. In October 2008 a squeeze briefly made Volkswagen the world's most valuable listed company. In January 2021, retail investors coordinating online pushed up the share price of GameStop, a heavily shorted US retailer, causing large losses for some hedge funds and leading brokers to restrict trading. Squeezes illustrate why short positions are riskier than long ones of the same size.

• United States. The SEC's Regulation SHO (2005) requires brokers to locate shares before a short sale and to close out failures to deliver. Rule 201 (2010) restricts short sales to prices above the best bid for the rest of the day and the following day once a share falls 10 percent in a day. Monthly reporting of large short positions on Form SHO under Rule 13f-2 has been delayed, with the compliance date pushed to January 2028.
• European Union. The Short Selling Regulation (EU) No 236/2012 bans uncovered short sales of shares and sovereign debt, requires holders to report net short positions of 0.1 percent of a company's shares to the regulator and to disclose them publicly at 0.5 percent, and lets ESMA and national authorities impose temporary bans.
• Emergency bans. Many regulators banned short sales of financial stocks in September 2008, and several European countries did so again in March 2020. Studies of the 2008 bans generally found that they reduced liquidity and widened spreads without clearly halting price falls.

Short selling therefore remains contested: it is defended as a check on bubbles, such as economic bubbles fed by unchecked optimism, and a tool against fraud, and criticized as a source of instability and, when abused, speculation at others' expense.

• US SEC: Key points about Regulation SHO
• ESMA: Short selling