short selling

noun

1. finance the practice of selling commodities, securities, currencies, etc that one does not have in the expectation that falling prices will enable one to buy them in at a profit before they have to be delivered

More About Short Selling

What is short selling?

There are a lot of complicated ways to make money on the stock market, and a lot of complicated terms to describe them. Nonexperts can profit from some basic definitions, so let’s jump in.

One of the most basic stock investment strategies is known as a long position. This is basically when you buy shares of a stock, wait (sometimes for a long time) for them to increase in price, and then sell them, resulting in a profit—a.k.a. “buy low, sell high.”

But there are also ways to make money from a stock decreasing in price. One common strategy is called short selling. Short selling is a risky investment strategy in which an investor (called a short seller) borrows shares of stock, sells them, buys them back at a lower price, and then returns them, keeping the profit from the difference. This transaction is known as a short sale. Short selling is also known as selling (a stock) short or shorting a stock. 

Short selling is basically betting that a particular stock price will fall. Let’s break the process down into simple steps to make it easier to understand how short selling works. First, the investor borrows shares of stock from a stockbroker, under the conditions that the investor will return them on a certain date. Then, the investor quickly sells the shares to a buyer at the current market price. The investor then waits for the price of the stock to decrease. If (and it’s a big if) and when the price decreases to a level that the investor is happy with, the investor then buys the same amount of shares at the new, lower price. Finally, the investor returns the same amount of shares that they borrowed to the broker. At this point, the short sale is complete. The profit comes from the difference between the amount the investor originally sells the shares for and the amount they buy them back for.

Stock trading always includes some risk. For example, when you take a long position on a stock in the hopes that its price will increase and you can sell the shares at a profit, there’s no guarantee that it will increase in price. But your risk in this case is limited to the amount you originally paid for the shares.

In contrast, short selling is infinitely riskier because of the possibility that the stock might increase in price, forcing the investor—who is required to buy it back and return it by a certain date—to pay extreme amounts in order to meet these requirements. For this reason, the risk is literally unlimited.

One of the worst case scenarios when short selling is to get caught in what’s called a short squeeze. What is a short squeeze? To understand it, you first need to remember that short selling requires the short seller to wait for the price to go down before buying back shares in order to return them. But what happens when the price goes up, and keeps going up? If the deadline for the return of the shares is approaching, the investor is forced to buy the shares at the increased price before it surges even higher. The short seller is being pressured (“squeezed”) into buying the stock, most likely at a big loss. Sometimes, a short squeeze is the result of a coordinated effort by some investors to buy large amounts of a stock that has been the target of short selling, thus driving the price up and up, due to the demand from the short sellers to buy it back.

This use of the word short in the context of stock trading dates back to the mid-1800s. In this context, the word short was originally used in the sense of a person selling stock that they didn’t actually have. They were short of stock in the same way a person is said to be short (or short of cash) when they don’t have enough money to pay for something.

Example of short selling:

You’ve been doing your research, and you think that BiffCo Enterprises is going to have a poor quarter for profits, resulting in a decrease in its stock price. Through a broker, you borrow 100 shares of BiffCo stock, which is currently selling for $3 a share. Then, you quickly sell those 100 shares to a buyer for $300. Then you wait, closely watching the price of BiffCo shares. You were right—their share price dropped to $1 per share. You now buy back 100 shares of BiffCo stock for $100, return them to the broker, and pocket the remaining $200 in profit from the short sale.

Short selling used in a sentence: A lot of retail stocks have been the target of short selling because the brick-and-mortar retail sector is thought to be in decline.

What are some other forms related to short selling?

• selling short
• sell short
• short sale
• short seller

Why is short selling trending?

The term short selling started trending in January 2021 as a result of a short squeeze caused by investors buying large amounts of stock in GameStop (stock abbrev.: GME), a company that owns a chain of video games retail stores. Due to the shift to online shopping and digital markets, the companies behind brick-and-mortar stores like GameStop are often seen as being in decline. This has made their stock a target for short selling, in particular by major hedge funds—investment firms that specialize in high-risk investment strategies like short selling.

Here’s where it gets interesting. Some stock trading enthusiasts became aware of some hedge funds’ short selling of GameStop and other stocks and decided to take the risky move of trying to exploit those positions. This effort was led by a community of amateur stock traders on the social media site Reddit, specifically the subreddit (forum) /r/WallStreetBets. Their plan involved buying large amounts of GameStop stock, using online trading platforms such as Robinhood. The sudden buying spree caused GameStop stock to quickly rocket upward in price. The result was a short squeeze, in which the price continued to climb as short sellers (notably the hedge funds) desperately tried to buy back shares before the price increased even more.

This situation continued to escalate and gain mainstream attention, causing GameStop stock to become widely discussed as a “meme stock”—one that has seen an increase in trading activity after gaining popularity due to some online trend, as if the stock has gone viral. Traders then began buying shares in other companies that hedge funds had targeted as safe bets for short selling, including AMC Entertainment (AMC), Nokia (NOK), Naked Brand Group (NAKD), and Bed Bath and Beyond (BBBY).