Short (finance)
Based on Wikipedia: Short (finance)
In 1992, George Soros made a billion dollars in a single day by betting that the British pound would collapse. He sold short more than ten billion dollars worth of sterling, and when the Bank of England finally capitulated and withdrew from the European Exchange Rate Mechanism on what became known as Black Wednesday, Soros collected his winnings. He had, in the vivid phrase of the time, "broken the Bank of England."
This is what short selling can do. It is one of the most counterintuitive concepts in finance—a way to make money when things go wrong, to profit from decline, to bet against the house while everyone else is betting on it.
The Basic Mechanics
In ordinary investing, you buy low and sell high. You purchase shares of a company, wait for them to appreciate, then sell them at a profit. This is called being "long" a stock. It's intuitive: you own something, it becomes more valuable, you benefit.
Short selling flips this sequence around. You sell high first, then buy low later. How can you sell something you don't own? By borrowing it.
Here's how it works in practice. Imagine shares of a company called Acme Incorporated are trading at ten dollars each. A short seller believes the stock is overvalued and will fall. So she borrows one hundred shares from a broker—who typically gets them from another client's account—and immediately sells them in the open market for one thousand dollars.
Now she waits.
If she's right and the stock drops to eight dollars per share, she can buy back those one hundred shares for just eight hundred dollars, return them to the lender, and pocket the two-hundred-dollar difference as profit. Minus, of course, whatever fees she paid to borrow the shares in the first place.
But if she's wrong and the stock rises to twenty-five dollars, she's in trouble. She still owes one hundred shares to the lender, but now she has to pay twenty-five hundred dollars to buy them back. Her loss: fifteen hundred dollars.
This asymmetry is crucial. When you buy a stock normally, your maximum loss is what you paid for it—the stock can only go to zero. But when you short a stock, your potential loss is theoretically unlimited. A stock can keep rising forever. This is why short selling has a reputation for danger, and why it attracts a particular kind of investor: someone willing to bet against popular opinion with their own money on the line.
The First Short Seller
The practice appears to have been invented in 1609 by a Dutch merchant named Isaac Le Maire. He was a major shareholder in the Dutch East India Company, known by its Dutch initials as the VOC—the Vereenigde Oostindische Compagnie. The VOC was the world's first publicly traded company and arguably the first multinational corporation, with a monopoly on Dutch trade with Asia.
Le Maire had a falling out with the VOC's directors and wanted revenge. He began spreading negative rumors about the company's prospects while simultaneously selling its shares short. The strategy worked: the stock fell, and Le Maire profited. The VOC's directors were furious. They lobbied the Dutch government, which in 1610 banned short selling—making it the first of many such restrictions throughout history.
The ban didn't stick. Short selling kept resurfacing wherever markets developed, because it serves a genuine economic function. It allows investors who believe a stock is overpriced to express that view with actual money, which helps prices more accurately reflect reality.
How Borrowing Actually Works
The borrowing mechanism is more sophisticated than it might sound. When you borrow a friend's bicycle, you return the same bicycle. But when you borrow securities, you're returning equivalent securities—the same number of shares of the same company, not the exact same shares.
Think of it like borrowing a ten-dollar bill. If you borrow ten dollars from someone, you don't have to return that specific piece of paper. You just have to return ten dollars. Securities work the same way. They're fungible, meaning each share of a particular stock is interchangeable with every other share.
In practice, most short sellers borrow through their brokers. The brokers, in turn, typically get the shares from other clients who hold them in margin accounts. The legal agreements governing these accounts usually give brokers the right to lend out their customers' shares without specific notification.
The original owners don't lose their economic interest in the shares. They still receive any dividends paid—though technically the short seller, not the company, pays them. They can still sell their shares at any time; the broker simply borrows different shares to cover the loan. But they do lose their voting rights while the shares are on loan, which can matter during corporate elections or proxy fights.
Institutional investors like pension funds and mutual funds often actively lend their shares to earn extra income. They put up cash collateral, typically worth 102 percent of the shares' value, and receive interest payments in return. For large funds holding billions of dollars in stocks they intend to keep for years, this lending income can add up.
The Locate Requirement
Before you can sell a stock short in the United States, your broker must confirm that the shares can actually be borrowed. This is called a "locate." The broker doesn't necessarily have to have the shares in hand at the moment you place the order, but they must have reasonable grounds to believe the shares will be available for delivery when the trade settles.
This requirement exists because of a controversial practice called naked short selling—selling shares short without first borrowing them or even confirming they can be borrowed. Naked short selling is now effectively banned in most markets because it can create a kind of counterfeiting problem: more shares are promised than actually exist, which can disrupt the settlement process and, critics argue, artificially depress stock prices.
The locate requirement is one of several ways regulators try to ensure that short selling remains tethered to economic reality. Others include margin requirements—the obligation to post collateral that can cover potential losses—and disclosure rules that force large short positions to be reported publicly.
The Margin Call
Because your potential losses when shorting are unlimited, brokers insist on protection. When you open a short position, you must deposit collateral called margin. This is typically a percentage of the position's value, held in your brokerage account.
If the stock rises and your losses grow, your broker will demand additional margin. This is the dreaded margin call. If you can't meet it, the broker will close your position at the current market price, whether you want them to or not. You'll crystallize whatever loss has accumulated.
This mechanism creates a particularly brutal dynamic during "short squeezes." If a heavily shorted stock starts rising rapidly, short sellers face mounting margin calls. Some are forced to buy shares to close their positions, which pushes the price even higher, which triggers more margin calls for other short sellers, which forces more buying. The feedback loop can cause stocks to spike far beyond any reasonable valuation.
The most famous recent example was GameStop in January 2021, when a coordinated effort by retail investors on the Reddit forum WallStreetBets drove up the price of a heavily shorted video game retailer. Some hedge funds that had bet against the stock faced billions of dollars in losses. One, Melvin Capital, required a $2.75 billion cash infusion to survive. It later closed permanently.
Beyond Stocks: Derivatives
While borrowing and selling physical shares is the most straightforward way to short, it's not the only way. Financial derivatives—contracts whose value depends on the price of some underlying asset—offer alternative approaches.
A futures contract, for instance, obligates you to buy or sell something at a specified price on a specified future date. If you sell a futures contract on a stock, you're effectively betting the stock will fall. If it does, you can buy the stock cheaply in the market and deliver it at the higher price specified in your contract.
Options work similarly. A put option gives you the right (but not the obligation) to sell a stock at a specified price before a specified date. If the stock falls below that price, your option becomes valuable.
A contract for difference, popular in Europe and Asia though largely unavailable to American retail investors, is perhaps the purest expression of the short seller's bet. It's simply an agreement between two parties to pay each other the difference if an asset's price rises or falls. No actual shares change hands. If you take the "short" side of a contract for difference and the price drops, the other party pays you. If it rises, you pay them.
These derivative approaches have their own advantages and complications. They often require less capital than physical short selling and don't involve the mechanical difficulties of borrowing shares. But they also introduce counterparty risk—the possibility that the other side of your contract won't pay up—and they can be complex to understand and price correctly.
The Role of Shorts in Markets
Short sellers are perpetually controversial. To their critics, they're vultures profiting from misfortune, or worse, predators who actively create the disasters they bet on. Every major financial crisis brings calls to ban or restrict short selling. During the 2008 financial crisis, the Securities and Exchange Commission temporarily prohibited short sales of financial stocks. During the COVID-19 pandemic, several European countries imposed similar restrictions.
The academic evidence, however, suggests these bans don't work and may even be counterproductive. A comprehensive review of the 2008 restrictions found that they failed to slow stock price declines while increasing trading costs and reducing market liquidity. The prices of banned stocks actually fell more than similar unbanned stocks.
Why? Because short sellers play a legitimate role in what economists call "price discovery"—the process by which markets determine what things are actually worth. If only optimists can easily express their views by buying stocks, prices will tend to be biased upward. Short sellers provide the pessimistic counterweight.
More concretely, short sellers are often the ones who uncover fraud. The hedge fund manager David Einhorn was famously short Lehman Brothers before its collapse, having published research arguing the investment bank's accounting was suspect. The small investor community that exposed accounting irregularities at the German payments company Wirecard included many short sellers who had bet against the stock. When short selling is banned or severely restricted, one of the market's early-warning systems gets switched off.
Famous Short Sellers and Their Prey
The history of short selling is punctuated by dramatic confrontations between short sellers and their targets.
Jacob Little, known as "The Great Bear of Wall Street," pioneered American short selling in the 1820s. He made and lost multiple fortunes betting against stocks, earning a reputation as the most feared speculator of his era. His career illustrated both the potential rewards and risks of the short seller's craft.
Short sellers were among those blamed for the Wall Street crash of 1929 and the subsequent Depression. President Herbert Hoover publicly condemned them, and J. Edgar Hoover—the Federal Bureau of Investigation director, no relation—announced he would investigate their role. Congress eventually passed the "uptick rule," which prohibited short sales during a downtick in prices, on the theory that this would prevent short sellers from piling on during declines. The rule remained in effect from 1938 until 2007, when the Securities and Exchange Commission removed it after concluding it was no longer necessary.
The 1772 collapse of the London banking house of Neal, James, Fordyce and Down—which precipitated a crisis that brought down almost every private bank in Scotland—was caused in part by massive short positions in East India Company stock, reportedly financed with customer deposits. It was an early demonstration that short selling, like any financial tool, can be used recklessly or fraudulently.
The Birth of the Hedge Fund
In 1949, a financial writer named Alfred Winslow Jones had an idea. What if you could buy stocks you liked while simultaneously shorting stocks you didn't? You'd profit if you were right about which stocks would outperform, but you'd be partially protected from overall market moves because your short positions would offset your long ones.
Jones created a fund to test this idea, and it worked remarkably well. His fund outperformed the market while taking on less risk than a traditional portfolio. The approach became known as "hedging," and Jones is generally credited with inventing the hedge fund—though the name itself wouldn't become common until decades later.
Today, many hedge funds use short selling as a core strategy. Some are "long-short" funds that try to profit from picking both winners and losers. Others are "dedicated short" funds that focus primarily on betting against overvalued companies. The most aggressive use leverage—borrowed money—to amplify their bets in both directions.
The Measurement of Short Interest
Stock exchanges track and publish data on short selling. The "short interest" in a stock is the total number of shares that have been sold short but not yet covered—that is, not yet bought back to close the positions. This is usually expressed as a percentage of the stock's "float," meaning the total shares available for trading.
A related metric is the "short interest ratio" or "days to cover," which divides the short interest by the stock's average daily trading volume. If ten million shares are sold short and the stock typically trades two million shares per day, the short interest ratio is five days. This represents how long it would theoretically take all short sellers to buy back their shares if they all tried to cover at once.
These metrics can signal investor sentiment. A very high short interest suggests many investors are betting against the stock. It might indicate the stock is overvalued—or it might set up a short squeeze if the skeptics turn out to be wrong. A rising short interest can be a warning sign; a falling one might indicate that short sellers are capitulating.
The numbers don't tell the whole story, though. They typically reflect positions held through registered broker-dealers and may miss short positions created through derivatives or in overseas markets. And they're usually published with a delay, meaning by the time you see the data, the situation may have changed.
The Ethics of Betting Against
Is there something unseemly about profiting from decline? About hoping, in effect, that a company fails, that workers lose their jobs, that shareholders suffer?
Short sellers often argue that they don't cause bad things to happen; they merely identify bad situations and bet accordingly. George Soros didn't break the Bank of England—the British government's unsustainable currency policy broke it. Soros just recognized the situation for what it was and positioned himself to profit when the inevitable happened.
There's a certain logic to this defense. A doctor who diagnoses a tumor isn't causing the cancer. A fire inspector who identifies hazards isn't causing the fire. Short sellers, in this view, are diagnosticians of corporate disease.
But the analogy has limits. Doctors and inspectors don't profit from the diagnoses they make. And in some cases, short sellers do more than diagnose—they actively publicize their concerns, write research reports, give media interviews, do everything they can to convince others that a stock is overvalued. This can become a self-fulfilling prophecy if enough investors are persuaded to sell.
The counterargument is that this is exactly how markets should work. If a short seller has done genuine research and discovered that a company is lying about its finances or otherwise deceiving investors, shouldn't that information be shared? The alternative—letting frauds continue because no one has an incentive to expose them—seems worse.
The Permanence of Short Selling
Despite four centuries of periodic bans, restrictions, and public hostility, short selling persists. It persists because it serves functions that markets need. It provides liquidity—someone to buy when others want to sell. It helps prices reflect reality rather than optimism alone. It creates incentives to uncover fraud and incompetence.
It also persists because people are, frankly, often wrong about the direction of stock prices, and short selling offers a way to express and profit from contrarian views. In a world where cheerleading is more common than skepticism, where executives and analysts have incentives to talk their books, short sellers provide a useful counterweight.
The practice will always be controversial. When a short seller is right—when the company really is a fraud, when the stock really does collapse—they look like heroes, or at least like people who saw what others missed. When they're wrong—when the company succeeds despite their skepticism, when the stock rises and they lose money—they look like failed pessimists, or worse, like people who tried to destroy something good for their own profit.
But the mechanism itself is morally neutral. It's a tool for expressing a view about value. Like any tool, it can be used well or badly, skillfully or clumsily, for good purposes or bad ones. The stock market would be a different place without it—less efficient, probably, and more vulnerable to the kind of widespread fraud that thrives when no one has an incentive to look too closely.
Isaac Le Maire, the Dutch merchant who invented the practice four hundred years ago, might be surprised to see how his innovation has spread and evolved. But he would probably recognize the essential logic: if you think something is worth less than people are paying for it, short selling lets you put your money where your mouth is.