Let’s take a look at a few examples!
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Short selling is an expression that comes up often in discussions and news reports about the investment market, and is a popular activity among traders.
It most recently came into the limelight in early 2021, when members of the WallStreetBets subreddit channel started buying stocks whose shares had been sold short in great proportion, triggering a sharp increase in their price and leading to what is called a “short squeeze”. As investment ideas spread fast through trading chat rooms and social media, retail investors started chasing the most shorted stocks in the hopes of huge profits, causing turmoil on the market.
But what is short selling exactly, what does it entail? We will explain in detail in this article.
Short selling in the spotlight
How does short selling work?
What Is Short Selling in the Stock Market?
A short sale, often referred to as shorting, is a trading strategy where an investor sells a stock they have borrowed, hoping to repurchase it later at a lower price and profit from the difference. This approach is essentially the opposite of taking a long position, where an investor buys a stock expecting its price to rise.
To short a stock, you must typically have a margin account with your broker. The process begins by borrowing shares—usually arranged through your brokerage—and immediately selling them at the current market price. At some point in the future, you must buy those shares back and return them to the lender. If the stock price has dropped by then, the difference between the selling price and the repurchase price becomes your profit.
Who Lends the Shares?
In most cases, the shares are borrowed through your broker, who locates them from other investors or institutions. Since this is effectively a loan, the broker generally charges interest or borrowing fees for the duration of the short position.
Because the borrowed shares do not belong to you, they must eventually be returned to the lender. Therefore, short sellers hope the stock price will decline after the initial sale, allowing them to buy it back at a cheaper price.
However, if the stock price rises instead of falling, the position begins to accumulate unrealized (floating) losses. Unlike traditional stock purchases, the potential losses from short selling can be significant if the price keeps increasing.
Closing a Short Position
Closing a short trade is known as covering the position. This simply means buying back the shares you originally borrowed and sold. Depending on the price at the time of repurchase, the trade may result in either a profit or a loss.
Can a Broker Force You to Close a Short Position?
Yes. In certain situations, your broker may force you to close part or all of a short position through a process known as a buy-in.
This usually happens when a stock has very high short interest, meaning many traders have borrowed and sold the same stock. If the shares become difficult to borrow or lenders request their shares back, the broker may require short sellers to repurchase the shares immediately at the current market price.
Buy-ins are more likely to occur with stocks that have limited trading liquidity or a small number of shares available for borrowing.
Short selling in the spotlight
Let’s take a look at a few examples!
Shorting one share of Company Short
- Company Short is trading at $50 a share, but you strongly believe that its price will drop soon, maybe because you expect disappointing earnings or you know that the star CEO will leave soon.
- You borrow one share from your broker and the you immediately sell it at the $50 per share market price.
- Company Short’s price drops to $40 per share in line with your expectations.
- You buy the share on the open market for $40 and return it to the lender.
- Your gain is the $10 difference the two prices ($50-$40), minus transaction costs.
What happens if the stock price rises?
- So you have already borrowed the stock at sold it at $50 per share.
- However, Company Short’s price unexpectedly jumps to $70 per share.
- In order to limit your losses, you want to cover your short position so you buy back the share and return it to the lender.
- You suffer a $20 loss ($50-$70), plus commissions and fees.
Why Short Selling Can Be Extremely Risky
Unfortunately, the risks of short selling can be much greater than many investors initially expect. Let’s consider what happens if the stock price rises sharply instead of falling.
If you short a stock at $50 and its price increases to $100, your loss would already be $50 per share, not including any transaction or borrowing costs. Now imagine the price climbing even higher—what if it triples or quadruples?
Unlike buying a stock, where the worst possible outcome is losing the amount you invested, short selling carries theoretically unlimited risk. This is because a stock’s price can continue rising without any defined ceiling. As a result, losses on a short position can grow indefinitely as the price increases.
This is why short selling is widely considered a high-risk trading strategy, typically used by experienced traders rather than beginners.
Short Squeezes
A dramatic rise in the price of a heavily shorted stock can trigger what is known as a short squeeze. This occurs when short sellers rush to close their positions by buying back shares, which pushes the price even higher. As more short sellers cover their positions, the upward momentum intensifies, creating a chain reaction.
The GameStop Example
A well-known example of a short squeeze occurred in early 2021 with the struggling U.S. electronics retailer GameStop.
At the time, several hedge funds had taken large short positions in the company, expecting its share price to fall. However, retail investors coordinating through online communities began aggressively buying the stock.
At the start of the year, GameStop shares were trading at roughly $17. During the peak of the frenzy, the stock surged to nearly $500 per share, representing an increase of almost 30 times its initial value.
GameStop was not the only company affected. Other heavily shorted stocks also experienced dramatic price spikes, including:
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Bed Bath & Beyond, a U.S. home goods retailer
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Nokia, the Finnish telecommunications company
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AMC Entertainment, a major movie theater chain
Retail investors searching for stocks with high short interest helped push prices upward, creating significant market volatility. The situation led to short squeezes, temporary trading restrictions at some brokerage platforms, and substantial losses for certain hedge funds.
While some investors made significant gains, others—both professional and retail traders—also suffered considerable losses.
Despite the extreme volatility and record trading volumes during this period, financial regulators later reported that the core infrastructure of U.S. stock and commodity markets remained stable and resilient throughout the events.