What is short selling? Investing Explained

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s short selling. 

What is it? 

A trading strategy that aims to benefit from the fall in the price of a share, a bond, a commodity, a currency or a stock market index. It is risky, potentially lucrative. US short sellers are reported to have lost $572billion between 2019 and 2021, according to analytics group S3 Partners. But in 2022, they made profits of about $300billion, having bet that shares such as those of electric vehicle maker Tesla were set to tumble. 

How does it work? 

An investor convinced that a company’s shares are set for a sharp decline borrows a parcel of those shares from an existing holder such as a fund. The trader sells shares, hoping they will fall. The next step is to buy them back later at a reduced price, to be returned to the owner. The profit comes from the difference between the price at which the shares were sold and the price at which they were bought back. 

Finger on the pulse: The direction of share prices can confound even the most seasoned investor

What can go wrong? 

A lot. The direction of share prices can confound even the most seasoned investor. Technically, a short seller’s losses can be unlimited because, in theory, a share can keep rising and there is no cap on the amount you might have to pay to buy the shares back. When a share price unexpectedly surges, short sellers can be caught by what’s known as a ‘bear squeeze’. 

Is it new? 

It’s been around since share trading began in the 1600s in the Netherlands. It has been banned several times. ‘Naked’ short selling – shorting shares without first borrowing them – is illegal in the US, and in the UK under rules adopted from the EU. The entire short selling regime is to be amended under the Chancellor’s proposed Edinburgh reforms of the financial services sector, which are under consultation.

Is short selling a bad thing? 

Views differ. Some contend that short selling is a key component of an efficient stock market because it allows ‘price discovery’ – revealing what a share is really worth. 

But short sellers also stand accused of causing a share price to subside, or aggravating that decline, sometimes turning into a rout. They are also sometimes said to be profiting from misfortune. 

What shares are being shorted? 

The list of stocks, drawn up by the Financial Conduct Authority includes Asos, Kingfisher, Boohoo, Hammerson and Currys. Investors should regularly check this list.

Why Would a fund lend shares? 

For the fees. Institutions worldwide earned revenues of $12.5billion from lending of this sort, according to S&P Global Market Intelligence. In the pensions crisis, sparked by last year’s mini-Budget, some investors shorted government gilt-edged stocks as the prices of these bonds fell. Institutions lending to these short sellers earned some $182.4m. 

Who are the big shorts? 

The most famous is Michael Burry, founder of Scion Capital, whose bets on the US subprime housing market ahead of the global financial crisis were chronicled in The Big Short by Michael Lewis, which was later made into a film. Anyone interested in Burry’s views on today’s scene should follow him on Twitter (where he uses the name Cassandra B.C.) other players include Carson Block of Muddy waters Research.