The Short in a Nutshell

The simplest explanation of shorts you’ll read today.

At its most basic essence, selling short is selling an IOU note. There are several variations on how a “short sale” works, but at the end of the transaction, here’s the situation:

That’s it. From the perspective of the short seller, they have effectively sold an IOU (“I owe you”) note denominated in shares of a specific stock. This is true for both “naked” shorts and “covered” shorts. After the initial short sale, the short seller has the same type of asset gained (cash) and the same obligation (delivery of a share of stock to someone else by a given deadline).

The difference between the two is that in a naked short, the person who paid cash is also the one holding the IOU. The requirement to “borrow” a share theoretically curbs the worst abuses of short selling, because it slows down the process of selling shorts. However, as seen in the diagram below, once the short seller sells the short, they’re in the same risky position until they close the short sale by buying 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.

Unless the short seller owns the stock, the risk attached to this is theoretically unlimited, which makes short sales potentially dangerous. For example, if someone shorted $10,000 of Nortel stock at a short price of $4 per share in September 2002 just before it bounced up to $12 per share, they would have had to pay out $30,000 buying Nortel stock for other people.

A short mainly a tool for speculation, rather than investment. For people who own a stock and expect the stock to drop in value, it’s easy to simply sell the stock immediately. For shareholders who want to hedge against risk, there are other options, particularly a put (the right to sell a particular stock at a given price).

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.

When a stock price tumbles under pressure from short sales, that means a lot of shareholders are losing money to short sellers. In other words, when short selling pushes down stock prices, speculators win and investors lose. However, if current shareholders don’t panic and sell in response to aggressive short selling, then short selling can have the complete opposite effect on a company’s share price, driving it up.

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.

If people who own the stock button up and wait for the short contracts to come due, they can set their prices for selling stock sky-high and the short sellers are forced to buy at high prices.

This is not a tactic newly invented on Reddit for the purpose of trying to screw over hedge funds. Short squeezes have happened before; what’s remarkable in this particular case is that “retail investors” (the little guys) started the squeeze instead of a large company or a hedge fund manager. Note that although this was started by Redditors, larger players likely became involved quite quickly; once a short squeeze starts, the incentives to participate are obvious.

What happened was that certain hedge funds made very risky bets, and Redditors happened to be the first ones to call that risky bet.

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

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