Understanding Stock Shorting: How It Works and Real-World Examples

Shorting a stock, also known as short selling, is a financial strategy that allows investors to profit from the decline in a stock’s price. While it can be a lucrative technique, shorting also carries significant risks. On this article we want to explain how shorting works in a simple way. For this we will remind real-world examples of infamous short-selling cases, and some examples to help anyone get the concept. If you’re interested in learning about stock market strategies, stock investing, or financial markets, this place is for you.

What Is Shorting a Stock?

Let start describing what is actually ‘Shorting a stock’. This is the act of borrowing shares from a broker and selling them immediately at the current market price. The goal is to buy those shares back later at a lower price, return them to the lender, and get the difference as profit. This strategy is commonly used in financial trading, particularly in the stock market.

The Process of Short Selling

Short selling consists in the following process:

1. Borrowing Shares: The investor (the “short seller”) borrows shares of a stock from a broker. The broker charges interest or a borrowing fee for this service.
2. Selling the Borrowed Shares: The short seller sells the borrowed shares in the open market, generating cash at the current price.
3. Buying Back the Shares: Later, the short seller purchases the same number of shares—hopefully at a lower price.
4. Returning the Shares: The short seller returns the borrowed shares to the broker, closing out the position. The profit (or loss) is the difference between the selling and repurchasing prices, minus fees and interest.

An Example of Short Selling

Imagine a stock trading at £50 per share. You believe its price will fall, so you decide to short it:

1. You borrow 100 shares from your broker and sell them for £50 each, earning £5,000.
2. A week later, the stock price drops to £40 per share. You buy back 100 shares for £4,000.
3. You return the shares to your broker and pocket the £1,000 difference (minus any fees and interest).

However, if the stock price rises instead of falling, your losses can be significant. Let’s explore what happens when the stock price rises sharply:

• If the stock price rises to £100 per share, buying back 100 shares would cost you £10,000. Subtracting the £5,000 you initially received from selling the shares, you would incur a £5,000 loss (plus any fees).
• If the stock price skyrockets to £500 per share, buying back 100 shares would cost you £50,000. This would result in a staggering £45,000 loss.

These examples highlight the unlimited loss potential of short selling, as there is no upper limit to how high a stock price can go. Understanding stock trading risks and strategies is crucial when engaging in such practices and this post is to make you aware in how super risky short selling can be.

Risks of Short Selling

Short selling is inherently risky because:

1. Unlimited Loss Potential: Unlike regular stock purchases, where the maximum loss is your initial investment, short selling has no upper limit to potential losses.
2. Margin Requirements: Brokers often require you to maintain a margin account and may demand additional funds if the stock price rises significantly.
3. Market Squeezes: If many traders are shorting a stock and its price rises rapidly, they may rush to buy shares to close their positions to avoid higher loses. This demand will be driving the price even higher. This is called a short squeeze.

Real-World Examples of Short Selling

1. The GameStop Saga (2021)

One of the most infamous recent cases of short selling involved GameStop, a struggling video game retailer. Hedge funds like Melvin Capital heavily shorted GameStop shares, betting that the company’s value would decline further. However, retail investors on the Reddit forum r/WallStreetBets coordinated to buy up GameStop stock, driving the price sky-high in a phenomenon known as a “short squeeze.”

GameStop’s stock price skyrocketed from under $20 to over $300 in January 2021, leading to massive losses for hedge funds that had shorted the stock. Melvin Capital reportedly lost billions and had to receive a bailout from other firms. This highlighted the power of retail investors and the volatility of financial markets.

2. The Big Short (2008 Financial Crisis)

The 2008 financial crisis saw some investors profit massively by shorting mortgage-backed securities. Michael Burry, a hedge fund manager featured in the movie The Big Short, identified that the housing market was built on unstable subprime mortgages. He bet against these securities by purchasing credit default swaps, essentially shorting the housing market. When the housing bubble burst, Burry’s fund made over $700 million in profits. This case remains a classic example of short selling in financial history.

3. Tesla vs. Short Sellers

Tesla, the electric vehicle company led by Elon Musk, has been a target for short sellers for years. Critics believed Tesla was overvalued and bet heavily against the stock. However, Tesla’s stock price defied expectations, soaring from under $50 in early 2020 to over $1,000 in subsequent years. Short sellers collectively lost billions as the stock price climbed. This shows how stock market dynamics can surprise even experienced investors.

4. Lehman Brothers Collapse (2008)

During the 2008 financial crisis, short sellers targeted Lehman Brothers, a global financial services firm. As concerns about Lehman’s solvency grew, short sellers amplified pressure on the stock. Lehman’s share price plummeted, and the firm eventually declared bankruptcy. This case sparked debates about the ethical implications of short selling during financial turmoil.

A Simple Illustration: The Lemonade Stand

Not clear yet? Lets make it even simple with more ‘tangible’ things. Imagine a neighbourhood lemonade stand where a glass of lemonade sells for £1. You believe the price will drop soon, so you borrow 10 glasses from the stand owner and sell them to your neighbours for £10. Remember, you borrowed those glasses of lemonade so you must return them to the owner.

Later that week, the price drops to 50p per glass. You buy back 10 glasses for £5 and return them to the stand owner. Your profit is £5 (£10 – £5), minus any borrowing fees.

But what if the price rises instead?

• If the price rises to £2 per glass, buying back 10 glasses would cost you £20, resulting in a £10 loss.
• If the price rises to £5 per glass, buying back 10 glasses would cost £50, leading to a £40 loss.
• If the price soars to £10 per glass, you’d need £100 to buy back the glasses, incurring a £90 loss.

This shows how rising prices can exponentially increase losses when short selling. This example simplifies stock market concepts for beginners.

Should You Consider Short Selling?

Short selling is a sophisticated investment strategy that’s not suitable for all investors. It requires a deep understanding of the market, the ability to monitor positions closely, and the financial capacity to handle potentially unlimited losses. Here are some considerations:

1. Experience Level: Beginners should avoid short selling until they have a solid understanding of stock market dynamics.
2. Market Research: Successful short selling requires thorough research to identify overvalued stocks or industries.
3. Risk Tolerance: Only investors with a high risk tolerance and sufficient capital should engage in short selling.
4. Alternative Strategies: Consider less risky strategies like buying put options, which limit potential losses to the amount invested.