How Financial Markets Work: Behind the Scenes
Short Selling
How investors can profit from falling prices by borrowing and selling shares, the risks involved, and why short sellers are both criticised and valued.
Most investors buy shares hoping prices will rise. Short sellers do the opposite: they aim to profit when prices fall.
How it works
- The short seller borrows shares, usually through a broker, from an investor who owns them.
- They sell the borrowed shares at the current price.
- Later, they buy the same number of shares back, hopefully at a lower price.
- They return the shares to the lender, keeping the difference as profit, minus borrowing fees.
If the price falls from 100 to 70, the short seller gains 30 per share. If it rises to 130, they lose 30 per share.
The risks
Short selling is risky:
- Potentially unlimited losses: a share price can fall at most to zero, limiting a buyer’s loss, but it can rise without limit, so a short seller’s losses have no ceiling.
- Borrowing costs: lenders charge fees, sometimes high for hard-to-borrow shares.
- Short squeezes: if prices rise sharply, many short sellers may rush to buy back shares at once, pushing prices even higher.
The GameStop short squeeze
In January 2021, many small investors, coordinating partly through online forums, bought shares of GameStop, a video game retailer heavily shorted by hedge funds. The price rose from under 20 dollars at the start of the month to over 300 dollars at points in late January. Some short sellers suffered huge losses. The episode drew attention to short selling, online communities and market structure.
In 2020, short sellers and journalists raised concerns about Wirecard, a German payments company, before its fraud was confirmed. Earlier, short seller research helped expose problems at other companies. By betting against overvalued or fraudulent firms, short sellers can help bring hidden problems to light and push prices toward realistic values.
Regulation and debate
Critics argue short sellers can drive down prices, spread negative rumours and worsen panics. During crises, regulators in several countries have temporarily banned short selling of certain shares. Supporters, including many economists, argue short selling improves price accuracy and liquidity, and that bans often have little benefit. India allows short selling for all investors, with requirements such as delivering shares at settlement.
Short sellers profit when prices fall, but companies usually fail because of their own problems, not because someone bet against them. Short sellers often identify weaknesses that already exist.
- Short sellers borrow and sell shares, hoping to buy them back cheaper later.
- Potential losses are unlimited because prices can rise without limit.
- Short squeezes, like GameStop in 2021, can cause huge losses for short sellers.
- Short selling can expose fraud and improve prices, but is controversial in crises.
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