What is short selling?

What do you know about investing? If you’re an absolute beginner, you might only know “buy low, sell high.” That rule is easy to understand. If you buy a stock for a low price and sell it for a high price, you make a profit. But what if you could make money from the opposite? What if you could buy high, sell low, and somehow make money doing it?Welcome to the world of short selling. Let’s walk you through one of the most interesting and controversial ways to make money off stocks. 

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How does short selling work? 

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Short sellers make money when a stock price falls. They usually do this by borrowing a stock first. Let’s look at an example. 

1. A short seller borrows 1 share of Apple, worth 127 Euros. They immediately sell it on the market for that price. 
2. The short seller waits for Apple’s share price to drop. After a few weeks, the stock sinks to 100 euros. 
3. The short seller now buys a share for 100 euros, and returns it to the investor they borrowed it from. 
4. They keep the remaining 27 euros as profit. 

And that’s it! By borrowing the stock and rebuying it, short sellers profit off of sinking stock prices. The lower the share price sinks, the more profit the short-seller makes. 

There’s a risk here too. Let’s say you short a stock at $50, but it rises to $150. You’ve lost $100, more than double of your initial investment. 

If you’re buying a stock, or going long, in investor-speak, the most you can lose is 100%. But if you’re shorting, you lose money the higher the stock goes, which means your losses can go way higher than 100%.

On its face, that seems like a reasonable thing to be able to do. And still, if you’ve ever come across the term “short seller,” it’s probably been with a negative connotation. Why is that?

The ethics of short selling

When you buy a stock, you usually want its price to increase. You have a financial incentive in that specific outcome — you only make money if the price increases. It’s understandable that you’d then be enthusiastic about the stock. Maybe you share your enthusiasm with friends, or even in a post online, talking about how you believe the company you invested in is destined for greatness. 

In the same way, short sellers have a financial incentive in seeing a stock decline. Usually they believe the stock is going to inevitably decline, either because it’s gone too high, or they believe the company won’t do as well in the future as it is now. Like the investor from above, they might also share that information publicly. 

This is where we get into more complex territory. Some funds specialize in short selling. They hunt for stocks they think are overvalued, and short them. Once they do, they frequently publish detailed reports explaining their thinking. Here’s an example of one by a short seller, Citron, known for their dramatic reports and inexplicable use of the Comic Sans font. Interestingly, the company stopped publishing these reports in January 2021 after the Gamestop short squeeze. If you didn’t follow it, the short squeeze involved pumping the price of Gamestop shares so high that short sellers of the stock were set to lose a lot of money.

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A Citron Research report

These reports serve two purposes: one is to explain to other investors exactly why the short seller thinks the share price will go down. The other is to convince them to join. This is the more ethically complex part of short selling: if you can convince enough people that a stock price will fall, they’ll all sell their stocks or go short, and the stock will fall, whether it deserves to or not. 

It’s like the opposite of the memestock phenomenon: instead of having a stock go up for no reason, it goes down for no reason. With memestocks, people don’t usually mind, even if they are concerned about a potential bubble. But when a stock sinks because a short seller convinced a lot of people it would, people are more upset. For one, a lot of shareholders lose money in this scenario. Secondly, the company also might have trouble securing financing based on its share price. 

Short sellers defend their actions by saying they’re contributing to the price discovery — the push-and-shove between believers and non-believers that eventually leads to a company’s share price being an accurate portrayal of its worth. By allowing both optimists (the investors) and pessimists (short sellers) to exist, it makes sure that stocks don’t go up too fast or turn into bubbles. 

Who’s right in this debate is almost irrelevant. What’s more important is to know that short sellers exist, how they work, and how they affect the market. After all, you can’t always buy low and sell high.