What is short selling?Medium

Selling something you borrowed, in the hope of buying it back cheaper. The loss has no ceiling, and the position grows as it goes against you.

4 min read · 727 words

The short answer: you borrow a share from somebody who owns it, sell it immediately, and hope to buy it back later for less. You return the share to the lender and keep the difference. If the price rose instead, you buy it back for more and the difference is your loss.

The four steps, and the one people skip

1. Borrow. Somebody who owns the share lends it to you for a fee. This is securities lending, and it is a real market with a real price that changes daily.
2. Sell. The share is sold to an ordinary buyer, who has no idea it was borrowed and does not need to.
3. Buy back. At some point you buy the same share in the market.
4. Return. The share goes back to the lender.

The step people skip is the first, and it is the one that creates most of the risk. You do not control how long the loan lasts. A lender can recall the share, and if you cannot borrow it elsewhere you have to buy it back now, at whatever the price is — which tends to be exactly when you least want to.

Why the loss has no ceiling

Buy a share and the worst case is it goes to zero: you lose what you put in. Short a share and there is no equivalent number, because a price can rise without limit. That asymmetry is the whole of what makes shorting different, and it is made worse by a second effect that is easy to miss:

The position gets bigger as it goes against you. A long position that falls becomes a smaller part of your portfolio; a short that rises becomes a larger one. Losing positions shrink and get quieter on one side, and grow and get louder on the other. Can I lose more than I put in is the page on that line.

A squeeze, mechanically

A squeeze is not a mood. It is what happens when a lot of people are short the same thing and the price starts rising: each of them faces a margin call, and the way to close a short is to buy. So the people who most need the price to fall are forced to push it up, which forces more of them, and so on until the shorts are gone. 2021 is the case study, and 2022 is the same mechanism in a commodity.

What it costs to hold

• The borrow fee, daily, and it rises exactly when a share is hard to borrow — which is when everybody wants to be short it.
• The dividend. You sold a share that pays one, so you owe it to the person you borrowed from. That is not a fee, it is an obligation you took on.
• Margin, posted and topped up. A short is a leveraged position whether or not anybody used the word.

Why it is allowed at all

Two arguments, both about the market rather than the short-seller. Prices are supposed to reflect what people think, and a market where only optimism can be expressed reflects half of that. And short-sellers are the participants with a financial reason to look for what is wrong with a company, which occasionally finds something everybody else missed. Against that, most restrictions on shorting exist because forced buying in a falling market can amplify a decline.

This page describes a mechanism. It is not a suggestion that anybody should short anything, and the asymmetry above is exactly why that would be a serious thing to suggest.

Doing it without borrowing anything

Most short exposure today is not assembled this way. A total return swap, a contract for difference or a bought put option all produce a similar payoff without the borrow — and each substitutes a different set of risks, the largest being that you now depend on the bank on the other side. 2021 is what that looks like when several banks hold pieces of the same position and none sees the whole.

The one sentence to take away

A short is a borrowed share sold today and owed back later, so the two things that end one are the price rising without limit and the lender wanting it back — and the second happens on somebody else's timetable.