Short Selling – everything you need to know

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Short Selling – everything you need to know

Recently a very small stock in the US made headlines in the investment community. Gamestop, a bricks and mortar retailer in the US, selling games and accessories for The PlayStation and Xbox. Very similar to EB Games here in Australia. The combination of COVID restricting shopping into stores, combined with the trend of the manufacturers to shift to subscription based online delivery for their games, suggested this was a business with its challenges.

Yet in the space of a few weeks at the beginning of 2021, this stock rose from a little over $19.00 a share to over $300 a share. It then fell back down to earth.

Much has been written about the impact of the Reddit community WallStreetBets and how a pack of individual investors sitting at home in front of their computer was able to have a win over the hedge fund managers. But to properly make sense if this fascinating storey, you need to have a good understanding of what short selling is and how it works. So let’s bring you up to speed.


Short Selling – definition

Short selling is when you sell a stock that you don’t own. That seems weird doesn’t it? How can you possibly sell something that you don’t already own? Indeed in Australia it’s not a straightforward thing to do with most brokers only allowing it for professional investors, and the ASX only allowing it on a limited number of shares. If retail investors look to make money through prices falling here in Australia, they’d typically do it through CFD’s or options at the individual stock level. There is also the ETF BEAR by Betashares that short sells the ASX SPI200 so that its value rises as the market falls.

An investment like this could be used as a form of insurance. For instance imagine you have a broad, long term portfolio with some significant capital gains tax liabilities embedded in it, meaning you don’t want to sell unless you have to. But you are concerned markets might fall in the short term, and due to some event going on in your life, there is a potential that you might need to come up with cash at short notice, which would necessitate a portfolio selldown. You could in that instance perhaps buy a short ETF, so that if the market falls the profits made on that short ETF will offset the losses seen on your portfolio, providing you with greater stability as to the overall value of your portfolio. Of course if markets rise your short ETF will lose money, but the rest of your portfolio should gain. Insurance is never free, but there are instances where it could be considered worthwhile.

Short sellers hope that the price of a stock will go down. When they enter a short position, there is an obligation at some point to buy the stock back and closeout the position. Balance it, if you like. A short seller might for instance buy a stock for $10, wait for it to fall to $8, and then buy that stock back at the lower price. In this way they’ve made themselves a $2 profit per share.

For investors who analyse stocks, short selling provides a way to make money out of those companies with poor prospects. Ordinarily as investors, we’re looking for stocks that we expect to rise. That means that someone analysing individual stocks discards plenty of the research that they do, because at the end of the research they conclude that it’s outlook isn’t sufficiently attractive. Via short selling, some of this discarded research can be put to use. When a stock analyst identifies a business with a poor outlook, they can still profit from the insight that they have gained by shorting it.

There are many who look negatively upon short selling. It can same like barracking for your team to lose. Don’t we all want markets to rise? Indeed in some countries short selling has been banned, typically for just short periods.

Generally, though regulators permit short selling, because one objective of markets is price discovery. That’s jargon for saying that the market is trying to identify what an appropriate and fair price is for any given stock. It’s argued that short sellers help arrive at that fair price more quickly, which is presented as a benefit to all.

An important aspect of short selling to be aware of is that the degree of potential loss is unlimited. When you’re a buyer of a share the worst that can happen is the share price goes to 0. Your total loss therefore is limited to 100% of your initial investment. The same does not apply to a short seller. You could short sell a stock at $10 hoping it will go down, but if in fact it rises, it could go to $100 or more and your loss is multiplying as it goes. There is no end point.


And that takes us back to the interesting story of GameStop.

Brokers are required to report all short positions, so the market is fully informed as to the degree of short selling on any given stock. This is known as the Short Interest. Looking up short interests on the Australian market just now I can see that Webjet is the most shorted stock, with 14% short interest. That means 14% of all the stock on issue is currently shorted.

GameStop somehow got to be 140% shorted. Now I’ve followed the markets for a long time and I can’t get my head around how a stock can be more than 100% shorted. It seems to be one of those only in America situations. Regulations here make it illegal to short stocks that you don’t own, which would therefore seem to prohibit anything over 100%. In any event what is clear is that there was a very high level of short interest in GameStop. Lots of investors thought this company was going down the toilet.

GameStop did however have some fans. And those fans liked to talk it up on the Reddit thread WallStreetBets. Now the action on WallStreetBets wasn’t the only thing going on. There were new board members added, and the business produced some numbers that suggested it wasn’t going as poorly as some analysts may have forecasted. But whatever the combination of drivers, what occurred was enough people buying the stock to start the price rising. Given short sellers potential for unlimited losses, and the need to ultimately buy back stock to closeout their short positions, as the price rose, short sellers were forced to buy stock to prevent their losses becoming catastrophic. This created a vicious cycle. As short sellers sought to closeout their position they bought stock, which pushed up the price. This convinced other short sellers that they also needed to closeout their positions, causing more demand to buy stocks and on and on it spiralled. Add to this the day traders watching this momentum and looking to participate and you have this extraordinary leap in share price over the course of just a few weeks.

There are considerable implications in this case around potential stock price manipulation that I’d imagine will get some attention in the months ahead. But for the purposes of this post the key takeaway is to highlight how short selling works, and an extreme case of how it can all go wrong. It’s reported that one US hedge fund with a substantial short position in GameStop required a capital injection of almost $3 billion to prevent it going broke as a consequence of the loss is incurred on this single bet.

Interested in learning more about stock market investing? Take a look at Invest in Shares with Confidence.

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