The Short in a Nutshell

The simplest explanation of shorts you’ll read today.

  • The short seller owes someone else one or more shares of a specific stock.
Diagram showing regular short sale and naked short sale, highlighting the second stage. The short seller must buy stock.
Diagram showing regular short sale and naked short sale, highlighting the second stage. The short seller must buy stock.
Standard explanation of a short. Emphasis added showing how the short seller has the same obligation whether or not the short is “naked.” Image remixed from 1 and 2. Original images by user Grochim on Wikimedia.

Weird Market Dynamics With Short Sales

There are two major ways that short sales can drive major movements in the stock price of a company that have nothing to do with the fundamental value of the company.

Herding Investors Off A Cliff

First, because short sales are a strong indicator that the seller thinks the stock will go down, short selling a stock prominently can drive its price down as existing shareholders worry about a future drop and try to sell. Aggressive and well-publicized short sales can cause the drop in share price that’s necessary for the short sale to make money.

The Short Squeeze

If too many traders decide to make too many short sales of a stock, on the other hand, the price of a stock can spike because there are too many people who need to buy the stock to fulfill their obligations. This recently happened with GameStop; hedge funds shorted more shares of Gamestop than existed.

A picture of a GameStop store
A picture of a GameStop store
Image of a GameStop store from here.

Dr. Tomas McIntee is a mathematician and occasional social scientist with stray degrees in physics and philosophy.

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