Short selling
In short selling you borrow shares, sell them and hopefully buy them back cheaper later. Your possible gain is limited, your possible loss isn't.
Learning objective: After this lesson you can explain why the risk of loss in short selling is unlimited, unlike when buying.
You borrow a share, sell it for €100 and hope to buy it back later for €80. Then you return it to the lender. The €20 difference is your profit, minus the lending fee.
The imbalance
The core is an imbalance. A share can fall no further than zero, so your gain is limited to €100. Upwards there's no limit. If the share rises to €300, you have to buy it back for €300 and have lost €200, twice what you got when selling.
Time pressure and fees
There's also time pressure. You pay lending fees continuously, and the lender can demand the shares back at any time. So you can be forced to close your position even if you'd have been right in the end.
The short squeeze
And there's the short squeeze. If many have bet on falling prices and the price rises, they all have to buy back at the same time. That drives the price higher still. In January 2021 GameStop shares rose more than tenfold within a few weeks this way, and several hedge funds lost billions.
An example trade with made up numbers
Sara borrows 50 shares and sells them at €40 each, so she receives €2,000. She sets her stop at €43. The borrowing fee is 3 percent a year, so about €5 for a month. Buying and selling cost €1 each.
If it works: The stock falls to €34. Sara buys the 50 shares back for €1,700 and returns them. She's €300 ahead, and after fees and borrowing costs €293 is left.
If it goes wrong: The stock rises and the stop buys back at €43. That's a €150 loss, €157 with costs.
If it goes badly wrong: Overnight a takeover offer is announced and the stock opens at €55. The stop only fills there. Sara loses €750, €757 with costs, five times what she planned. With short selling there's no natural limit on the upside.
The imbalance follows directly from a price not being able to fall below zero. The largest possible gain is the sale proceeds, the largest possible loss is theoretically unlimited. So for short sales you need stricter position size rules than for purchases, because your stake doesn't limit the loss.
Ongoing costs
There are also ongoing costs. The lending fee can get very high for shares many are betting against, sometimes double digits a year. If the company pays a dividend, you have to reimburse the lender. And because they can demand their shares back, there's always the risk you have to close, whatever the price does.
How a squeeze builds
A short squeeze happens when a rising price forces short sellers to buy back and those purchases amplify the rise. The larger the share of shorted stock among all freely tradable shares and the less is traded, the more vulnerable a stock is. It's the same mechanism as a chain of liquidations, just in the other direction.
Summary
- Gain limited, loss theoretically unlimited.
- Lending fees and the lender's right to recall create time pressure.
- A short squeeze is a chain of forced purchases upwards.
Did you get it?
Why is the loss in short selling unlimited?
Because the price can rise without limit while it can only fall to zero.
Which risk exists regardless of the price?
That the lender demands their shares back and you have to close.
How does a short squeeze happen?
A rising price forces short sellers to buy back, and those purchases drive the price further, especially if many have shorted and little is traded.
Check your understanding
Your task
You short 20 shares at $50 each. Calculate your gain or loss if the price falls to $35 and if it rises to $90, ignoring borrowing fees. Then compare your largest possible gain with the loss at $90.
Sources and further reading
- The U.S. SEC's summary of Regulation SHO explains the mechanics and disclosure requirements of short selling. View source ↗