The Short of It: Answers About Short Selling

Short selling can lead to headlines, whether it's because an activist investor came out with a bearish point of view or because of a short squeeze, such as the cases of GameStop (GME) and AMC Entertainment (AMC).

A short position is a trade that aims to profit from a decline in the value of a share of stock or another asset and is more common than some people think; Shorting happens every day in the financial markets in a variety of asset classes.

Short selling plays roles in price discovery and liquidity—two components of healthy and efficient markets. It's also used for risk management. However, it's not for everyone because there are numerous risks, and the mechanics are somewhat complex. But by understanding the basics of short selling and short interest, investors can gain some insight on companies and market dynamics.

We're going to answer some common questions about short selling and explain how it works, why people do it, and what the very real risks are.

Before you consider initiating a short position, it's important to understand the basics. Short selling stocks can quickly get complicated and risky.

With stocks, you can't sell it until you have it. To sell short, an investor—typically with help from a broker—needs to borrow the shares from someone else, and then sell those shares in the open market. At some point, the investor closes the short position by buying back the same number of shares in the open market and returning the borrowed shares to the owner.

If the price drops, the investor can buy back the stock at the lower price and pocket the difference. For example, if a stock shorted at $50 is bought back at $40, the seller realizes a $10 per-share profit (minus transaction costs). Of course, a stock shorted at $50 could increase to $60, so if the seller must repurchase the stock at that price, they'd lose $10 per share in addition to any transaction costs. Even if traders think their position will work out eventually, their brokers may force them to close the positions to comply with margin requirements.

Short selling is not for the fainthearted because the stock market has an upward bias and theoretically the price of the stock can increase indefinitely.

Short selling tends to be in the realm of hedge fund traders and other experienced market professionals with large amounts of capital and the capacity to absorb losses when the market moves against them. Typically, some professional traders might sell short if they're bearish on a certain stock or industry, or they may be angling for a change in management or the sale of the company.

Just like professional money managers who only take long positions, fund managers who engage in short selling do their homework. Many use fundamental analysis, poring over financial statements and other data in search of opportunity. Again, it's all part of the price discovery process.

Additionally, market makers—including professional option traders who provide liquidity to those markets—often need to sell short to hedge their exposure (what option traders call delta risk.)

There are two main reasons people sell short:

• Concern about a company's fundamentals
• Hedge long transactions

Professional short sellers do careful research and may uncover information that is contrary to a positive market opinion. Consider a biotech company that's pinned all its future revenue hopes on a drug still in clinical trials. The hedge funds and big banks deciding whether to go short or long on that biotech firm often employ doctors and scientists who are familiar with the field of medicine. If professional traders and analysts at the firms think the biotech company's management is perhaps too optimistic about getting regulatory approval or seeing positive trial results, they might short the stock. In cases like that, short sellers are playing a role in price discovery and sending a signal to possible buyers that the company may be getting over its skis.

In past decades, short sellers doing fundamental research have uncovered huge frauds. Ahead of Enron's bankruptcy, short sellers are credited for predicting the company's collapse before the shares became worthless, in addition to other corporate scandals of the early 2000s. While laws have been passed to prevent bad actors, scandals haven't been eliminated.

Hedgers, especially those associated with long-short hedge funds, also use short selling to make small bets within a sector. A typical long-short trade involves researching a sector and identifying the best and the worst company in it. Then, the fund manager might go long the top-performing firm and short the worst performer. This trade helps limit market risk through the offsetting position and allows the fund to benefit if the company it identifies as the best takes business from the company it identifies as the worst.

A short squeeze can happen when bullish news pushes a stock price higher, prompting short sellers to simultaneously head for the exits. As the shorts scramble to buy back and cover losses, upward momentum builds upon itself, and the stock can move sharply higher. The GameStop trade in 2021 is a classic example: lots of buying by both individual investors online and large firms sent the share price higher. Some people with large short positions bought shares to cover their short positions, forcing the stock price even higher.

A trader who writes an option is said to be short, but the transaction does not always involve borrowing. Some short options transactions have open-ended risk, while others limit risk to a certain dollar amount. For example, one popular options strategy is the covered call, which is a short call against a stock in your portfolio. If the stock price rallies through the options strike price and stays there through expiration, the worst-case scenario is that the option writer would have to deliver their stock to the option buyer. (Reminder, short options can be assigned at any time up to expiration regardless of the in-the-money amount.)

To sell a call option outright—on stock you do not own—is called a naked short call. Just like a short sale of a stock, risk is unlimited. As such, margin requirements are typically high, and many accounts aren't approved for naked call selling. To limit risk in a call-selling strategy, many traders opt for a short call vertical spread—the sale of a call and the simultaneous purchase of another call with a higher strike price. For a short call vertical, the risk is limited to the difference between the strikes, minus the net premium you received, minus transaction costs. There are various strategies for shorting options.

An alternate way to get short exposure to a stock is to buy a put option. A put allows the buyer the right—but not the obligation—to sell the underlying stock at the strike price on or before the options expiration date. With a long put, the most you could lose is the premium you paid for the option (plus transaction costs).

Market professionals follow key metrics, including "shorts as a percentage of float," which reflects the number of short-sold shares in proportion to the float, or the total number of shares available for trading in the public markets.

Most stocks have a small amount of short interest, usually in the single digits. The higher that percentage goes, the greater the bearish sentiment might be surrounding that stock. If the float reaches 10% or higher, some market pros consider it a red flag.

Data on short interest—the number of shares outstanding that have been sold short—is available for most U.S. companies listed on major exchanges. The New York Stock Exchange (NYSE) releases a short interest compilation every two weeks.

A glance at these reports often reveals familiar names. Examples might include a pharmaceutical company that's awaiting regulatory approval for a new drug or a retailer struggling to develop a viable long-term strategy. During a slump in commodity prices, energy or mining companies tend to be ranked among the most-shorted companies.

There are often stories beyond the numbers. Do you see any stocks you're considering as investments or that are currently in your portfolio? Think about why other people may have opposing viewpoints. Check recent earnings reports or listen to conference calls for color and context that may have implications for shareholders. Short interest readings are also available when you log in to your account at schwab.com.

To view short interest as a percentage of available float, select the Research tab, then Stocks, type in any symbol, and look for the data under Short Interest. A stock with 1.49% of short interest has a low percentage relative to the broader market.

Days to cover, or the short interest ratio, indicates how long it would take to cover, or buy back, all the shorted shares. This is calculated by dividing the number of shares sold short by the average daily trading volume; some view it as a measure of a stock's future buying pressure. Short sellers sometimes look for about seven days or fewer to cover before shorting a stock, because the longer the time period, the more likely for a squeeze to occur.

Some people ask if short selling is ultimately positive or negative for the market, but that's not quite the right question. Short selling, like going long, can be a key part of price discovery, and in the long run, price discovery is why we have markets in the first place.

Of course, short selling can have its negative aspects too. It's a complex strategy that's not for everyone and could expose you to quick losses if a trade goes against you. It's also not a good idea to short a stock out of spite against a company, something some traders have been accused of over the years.

Like any trade, shorting a stock successfully depends on correctly assessing the fundamentals, doing your research, and paying close attention to the market. Even then, the strategy could easily fail. Also, as in any trade, it's important to enter with an exit strategy in mind—for better or worse. Have a profit target as well as a pain point.

So, when you add it all up, what's the short answer about short selling? Even if you have no intention of short selling stocks, you might find value in understanding, and keeping an eye on, short selling metrics and dynamics.