How Short Selling Works

When we talk about short selling we are referring to an investment method in which the seller does not actually own the stock or asset that he wants to sell, but carries out this operation hoping for a future gain, even in a bear market.

So, is it possible to earn even when the markets are falling? Usually, when we think about investing, we intuitively associate this concept with the purchase of certain stocks at a low price with the aim of reselling them if the price increases. This intuition is the reason why very often the bull market is seen as favorable and full of opportunities, unlike the bear market. However, it is important to be aware that it is possible to take advantage of both the increase and the decrease of prices in the market.

Put like this, we do not actually understand what the underlying strategy is and, above all, the cases in which it is possible to use short selling. As we will see, short selling is a highly speculative way of operating, which can also carry considerable risks.

But let’s go step by step. Let’s better understand what is short selling, how it works, why it is practiced and how to operate in the markets where it is still permitted.

The meaning of short selling

Short selling is an investment strategy that allows market operators to profit from the decrease in the price of a security or financial asset.

Unlike the traditional approach, in which an investor buys a stock with the expectation that its value will increase (a "long" position), short selling involves selling a stock that the investor does not own, with the intention of buying it back later at a lower price.

In practice, short selling occurs when an investor borrows shares from a financial intermediary (usually a bank or broker) and immediately sells them on the market at the current price. Later, if the price of the stock falls, the investor can buy it back at a lower value, returning the shares to the lender and keeping the difference as profit.

However, short selling is a high-risk strategy because, unlike traditional investing in which the maximum loss is limited to the invested capital, short selling exposes the trader to potentially unlimited losses. If the price of the stock increases instead of falling, the trader will be forced to buy it back at a higher price, generating considerable losses.

Short selling is used not only for speculation but also for hedging, allowing investors to protect their portfolio from sudden market declines. For example, a hedge fund may short sell stocks in a declining sector to balance exposure to other investments.

Going short and long in the stock market: what does it mean?

In the context of financial investments, the terms "long" and "short" describe the directions of the positions that an investor can take with respect to an asset.

• "Long" position: the investor buys an asset with the expectation that its value will increase over time. In this scenario, the profit is made by selling the asset at a higher price than the purchase price. For example, if an investor buys 100 shares of a company at 50 euros each, he hopes that the price will increase so he can resell them at a higher price, thus obtaining a profit.
• Short position: the investor sells an asset that he does not own, borrowing it, with the expectation that its value will decrease. The profit is obtained by buying back the asset at a lower price and returning it to the lender. For example, if an investor believes that the shares of a company, currently listed at 100 euros, will decrease in value, he can sell them short. If the price drops to 80 euros, the investor buys back the shares at this lower price, returns them to the lender and makes a profit on the difference in price.

These two strategies are based on opposite market forecasts: those who go long believe in the growth of a stock, while those who go short bet on its devaluation.

Short selling is also often used in financial derivatives, such as put options and futures contracts, which allow investors to benefit from the decline of an asset without necessarily owning or borrowing the underlying stock.

One of the main reasons why traders choose to go short is the presence of bear markets, in which the general trend of prices is downward. In these cases, the possibility of making profits even in negative conditions is a great attraction for more experienced investors.

Short selling, here’s how it works (with a practical example)

Short selling occurs through a well-defined process that involves several phases.

1. Identifying the stock to sell short: the investor analyzes the market and identifies a stock that he believes is overvalued or destined to lose value. The analysis can be based on fundamental data, technical data or market news.
2. Borrowing shares from a broker: to sell short, the trader must borrow the shares from a broker or another investor. This operation involves the payment of a commission or an interest rate, known as the cost of borrow.
3. Selling the stock on the market: Once borrowed, the stock is immediately sold on the market at the current price.
4. Monitoring the stock price: The trader watches the stock’s performance: if the price drops, he can close the position by buying the stock back at a lower price, earning a profit.
5. Buying back the stock and closing the position: To close the position, the trader must buy back the stock and return it to the lender. If the price has dropped since the stock was sold, he makes a profit; if the price has increased, he suffers a loss.

For example, suppose an investor expects the price of XYZ company stock to decrease, which is currently trading at 100 euros per share. The investor borrows 10 shares and sells them on the market, earning 1,000 euros. The stock price subsequently drops to 80 euros per share. The investor buys back the 10 shares for 800 euros, returns them to the lender, and realizes a profit of 200 euros (1,000 euros - 800 euros), net of any costs associated with the loan.

It is important to note that short selling involves significant risks. Unlike a "long" position, where the maximum loss is limited to the amount invested, in a "short" position the potential losses are theoretically unlimited, since there is no upper limit to the price that a stock can reach.

Furthermore, if a stock sold short is involved in speculative operations or unexpected positive events, its price could rise rapidly, forcing traders to close losing positions. A prime example is the GameStop case in 2021, when a wave of buying by retail investors sent the stock price soaring, causing hedge funds that had short positions to lose billions. But we will return to this in detail later.

Is Short Selling Legal Today?

Currently, short selling is legal in most global financial markets, but it is subject to stringent regulation to prevent market manipulation and instability.

• United States: Regulated by the Securities and Exchange Commission (SEC), it has restrictions such as the Uptick Rule, which prevents you from shorting a stock if the price is falling sharply.
• European Union: Overseen by the ESMA (European Securities and Markets Authority), with reporting requirements for short positions exceeding 0.1% of a company’s share capital.
• Italy: Consob can impose temporary restrictions on short selling during periods of high volatility.
• Asia: Countries such as China and South Korea have more stringent restrictions, while Japan and Hong Kong have similar rules to Western ones.

Why and When to Short Sell

As mentioned above, investors hold "long" positions in the expectation that the instrument in question will increase in value in the future. The opposite of a "long" position is a "short" position, in which investors believe that the price of the security will decrease in value. Obviously, if the analysis is not appropriate and the market moves against the investor, the investor will record a loss.

Intuitively, many investors may think of a bullish market, i.e. a growing market, as richer in opportunities, as this concept is associated in the long term with a global expansion of the market itself. However, in reality it is also possible to take advantage of the bearish market, i.e. a falling market, and achieve profits in situations of market instability. Always remember that the market can also move against you, putting your capital at risk.

Therefore, the choice of going long or short depends on the analysis of each trader and the movements that the market is expected to make. Some investors prefer to focus on technical analysis, therefore mainly on the price movement, the graph, the models and the identifiable formations; while others prefer to use fundamental analysis, focusing on macroeconomic indicators and political events that could have an impact on the performance of an instrument.

These two analysis strategies are not mutually exclusive: they can be used in a complementary way, combining various price action, trend and pattern analysis tools, with fundamental elements such as economic-political releases and news.

Furthermore, obviously, the same investor can find himself taking long and short positions on different instruments at the same time, or buying and selling the same instrument at different times.

The risks of short selling

Short selling involves a series of risks that, as we have seen, can be significant. Therefore, investors must carefully consider market analyses and authoritative projections before undertaking this strategy.

In summary, we could list the main risks of short selling in four key points:

• unlike buying shares, where the maximum loss is limited to the invested capital (if the share price falls to zero), in short selling the losses can theoretically be unlimited. This is because the price of a share can increase indefinitely, exposing the investor to increasing losses;
• when the price of the shares sold short increases, the investor may receive a margin call from the broker, asking to deposit additional funds to cover potential losses. If the investor is unable to meet the margin call, the broker can close the position, realizing a loss;
• investors who sell short must pay a fee to borrow the stock. If the stock being sold short is hard to find or in high demand for borrowing, the cost of borrowing can increase, reducing the investor’s profits or increasing losses;
• finally, stocks can be subject to sudden and unpredictable price movements due to news, financial results, changes in market conditions, or other variables. Such movements can cause significant losses for investors who sell short.

The GameStop case and short selling: a lesson in modern finance

The GameStop case is one of the most emblematic events in the recent history of financial markets, which has highlighted the risks of short selling and the power of decentralized finance. It all started in 2021, when hedge funds like Melvin Capital sold large amounts of short shares of GameStop (GME), a video game retailer that was seen as declining due to the shift to digital content. Institutional investors believed the stock price would fall further, allowing them to profit from the difference.

However, a group of small investors, organized on platforms like Reddit (particularly the subreddit r/WallStreetBets), noticed the high level of short interest in GameStop, with over 140% of available shares sold short. Believing that the funds had undervalued the company and took advantage of the situation, they launched a coordinated buying campaign, sending the stock price skyrocketing from a few dollars to over $400 in a matter of weeks.

This unexpected increase triggered a phenomenon called short squeeze: short sellers, forced to buy back shares at increasingly higher prices to close their positions and limit their losses, further fueled the stock’s growth. Melvin Capital suffered billions in losses and was forced to receive a capital injection to survive.

The event raised questions about the ethics of short selling, market regulation, and the power of small investors compared to large funds. The SEC stepped in to investigate, while brokers like Robinhood temporarily limited the purchase of GME shares, triggering accusations of manipulation. The GameStop case has shown how short selling, although legal, can become extremely risky and how market dynamics can be influenced by new players thanks to social media and trading platforms accessible to everyone.

Original article published on Money.it Italy. Original title: Vendita allo scoperto, come funziona lo short selling