What is Short Selling and How Does It Work?

The term “short selling” originated in the stock market, an investor would borrow stocks from a broker to sell them, aiming to profit from a price decline. Essentially, “selling short” or “short selling” refers to selling an asset (such as stocks or commodities) that an investor does not own. The strategy is based on the expectation that the asset is currently overpriced and will be available at a lower price in the future.

Today, the term “going short,” or simply “shorting,” is widely used in trading and refers to selling a financial instrument. Conversely, buying an instrument is called “going long” or just “long.”

As explained, short selling involves borrowing stocks (typically from a broker) to sell them at the current market price, with the intention of repurchasing them at a lower price later to return to the lender. Short selling profits from declining prices, but it is an inherently risky strategy. This is because stock prices, in theory, have unlimited upside potential, meaning they can rise indefinitely, while their downside is limited to zero. As a result, a short seller faces unlimited potential losses but limited profit potential. This means an investor must be highly confident in the decline of an asset before shorting it.

However, as demonstrated in the GameStop case, even stocks perceived as failing can experience unexpected surges. In that instance, a group of retail traders coordinated on a forum to drive up demand for the stock by purchasing it collectively. This sudden price surge resulted in massive losses for Wall Street investors, such as hedge funds, that had shorted the stock. Since they were obligated to buy back the stock at the inflated price to close their positions, their losses were substantial.

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Advantages of Short Selling

Short selling has many advantages that attract many traders, new and experienced alike:

  • Short selling grants traders access to instruments that they would otherwise not be able to trade. If one wants to benefit from a decrease in an instrument’s value, he can do it without owning it.
  • Going short on an instrument, meaning opening a selling position on the platform, allows traders to benefit even when the markets are going down, as will be explained in the example later.
  • Short selling minimises the risk the trader takes. There is no need to buy and sell instruments in “real life”, rather trade them electronically and profit from the fluctuations. Moreover – should a person own crude oil, and its price drops dramatically and suddenly, the person is left with merchandise that is worthless from the time he bought it, and without potential buyers.
  • In short selling one can monitor and control his investment with the use of different market orders, stop loss and others. These can prove critical when short selling.
  • Just like going long, one can employ leverage in short selling, and open positions larger than his capital

 

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Disadvantages of Short Selling

Here are some of the disadvantages of short selling in the market:

  • Short selling involves borrowing a stock to sell at current market prices. There are charges applied for ‘borrowing’ such stocks and this adds to an investor’s overall trading costs.
  • Short selling is conducted on a margin trading basis, which opens up investors to the risk of margin calls as well as margin interests incurred for holding trades over a long period of time.
  • Numerous other factors drive stock prices other than real company fundamentals. Situations, such as a short squeeze, make short selling an inherently risky strategy.
  • Borrowed stocks may be recalled by the respective broker with investors having no control over the prices prevailing in the market. This exposes investors to the danger of selling stocks at a price they do not agree with.

 

Short Selling Example

Returning to this article’s favourite instrument – crude oil.

  • Say its price when the markets open on Monday is $44.50.
  • In regular trading, if a trader believes the price will rise, he will open a buying position, and if the price went up to $45.50, his profit is $1 for every unit sold.
  • With short selling the trader can act as the seller; if the expectation is for the price to drop, he would open a selling position for this instrument.
  • If the price got to $43.50, his profit is $1 and he can now close the position, meaning he “buys” the instrument for a better price.

The Power of Short Selling

Although controversial, short selling is very integral in creating efficient markets. Shorting stocks creates liquidity in the markets by ensuring there are always enough sellers for long positions to be exited efficiently. Short selling also contributes to the fair price discovery of the underlying asset and can also help investors to allocate capital effectively in their portfolios. Without short-sellers, markets would easily be prone to financial bubbles while massive fraudulent activities would not be uncovered. This is because a short-seller looks at an underlying stock with a very critical eye so as to uncover negative fundamentals. In contrast, it is easy for an investor that goes long in a stock to perform lacklustre research or even be blinded by optimism and euphoria.

Short Selling in Spread Betting

The same concept of short selling on regular trading, applies to spread betting. If one believes a certain instrument’s value will rise he can place $10, for example, for each pip the price moves. If, however, the instrument’s value is expected to decrease, he can place the same $10 for each point it goes down, and make the same profit.

Emerging Trends in Short Selling

Short selling, once regarded as a niche investment strategy, has become an integral and closely monitored component of financial markets. According to the Financial Industry Regulatory Authority (FINRA), short selling activity often intensifies during periods of market uncertainty. This was evident during the early months of the COVID-19 pandemic, when short interest surged significantly.

In response to heightened volatility, regulators across Europe took decisive action in 2020. The European Securities and Markets Authority (ESMA) implemented coordinated short selling restrictions among EU member states to stabilize markets and mitigate extreme fluctuations. These temporary bans illustrate the evolving role of policymakers in regulating short selling to safeguard financial stability.

The Role of Short Selling During Market Crises

Historically, short selling has been pivotal during economic downturns and crises, serving as both a profit mechanism and an indicator of underlying market vulnerabilities.

Michael Lewis’s “The Big Short” offers a striking example through Dr. Michael Burry’s well-researched short positions on subprime mortgages ahead of the 2008 financial crisis. His contrarian approach exposed systemic weaknesses and underscored the importance of data-driven analysis in short selling.

Academic research corroborates this view. A study by Asquith, Pathak, and Ritter (2005) published in the Journal of Financial Economics revealed that heightened short interest frequently precedes price declines, highlighting short sellers’ ability to anticipate overvaluations and deteriorating fundamentals.

Such findings position short sellers as early warning signals in overheated markets, often identifying systemic risks before they become apparent to the broader financial community.

Real-World Illustrations

Prominent figures in the short selling community emphasize its critical role beyond profitability. Jim Chanos, the founder of Kynikos Associates, underscores its function as a tool for uncovering overvalued business models and corporate malfeasance. Speaking to Bloomberg in 2020, Chanos stated:
“Short selling isn’t just a bet on a price drop; it’s a critical tool for risk management and discovering fraudulent or overvalued companies.”

Similarly, Andrew Left of Citron Research highlights the ethical dimension of short selling. In an interview with Reuters, he described short sellers as “whistleblowers” who challenge corporate misconduct, stating:
“Short sellers are often portrayed as villains, but many of us see ourselves as whistleblowers who expose corporate fraud.”

These practitioner insights reveal the broader value of short selling as a mechanism for enhancing market integrity and accountability, beyond its perceived speculative nature.

Short Selling Regulation

The regulatory landscape for short selling continues to evolve, emphasizing transparency and oversight to prevent market abuses.

Following the 2008 financial crisis, the U.S. Securities and Exchange Commission (SEC) reinforced its regulatory framework through Regulation SHO. This includes measures to curb abusive practices such as naked short selling. The SEC explicitly states:
“Naked short selling is generally illegal and may create artificial downward pressure on a stock’s price.”

In Europe, ESMA and national regulators have implemented stringent transparency requirements for net short positions. These measures aim to foster market integrity and maintain investor confidence, reflecting the balance regulators seek between enabling market efficiency and mitigating systemic risks. By highlighting both the risks and the opportunities of short selling, this practice remains a cornerstone of modern financial markets, blending strategic insight with regulatory vigilance.

Short Selling In Australia with AvaTrade 

Short selling is a well-accepted trading method, and can be applied to all types of instruments, whether you trade forex, commodities, stocks, bonds and others. Since it enables you to trade and benefit also when the markets are down, it is important to find a CFD broker that has a well-established trading record, which will help you decide whether you should go long (buying) or short (selling). This, with a combination of over 250 instruments, that AvaTrade offers to its clients, provides countless trading opportunities and high profit potential.

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Short Selling main FAQs

  • How can you manage the risk on a short sale?

    Because the potential loss on a short sale is unlimited it is critically important that traders work to proactively manage that risk. There are several ways to do this, including the use of a buy stop order to protect against the price of the underlying going up too much. An alternative is to place a trailing buy stop order that will follow the price of the underlying by the amount you specify and only trigger if the price goes against you. This allows you to let your winning short trades run.

     
  • Why would I want to sell short?

    Most people look to buy assets when the price is rising, but shy away from profiting from a falling price by short selling. However, there is nothing inherently wrong with making a profit from a falling price when you are bearish and believe the price will continue falling. This is especially true for short selling with CFDs where you aren’t actually selling the underlying asset, but are instead speculating on the changing price only.

     
  • What is naked short selling?

    A naked short sale is the illegal practice of short selling shares that do not exist. Typically, in short selling the trader must first borrow shares in order to sell them short. But with naked short selling there are no shares borrowed and so the short sale puts more short pressure on the stock that could be larger than the available tradeable shares. Naked short selling was made illegal in the wake of the 2008 financial crisis, but it still occurs at times due to loopholes in regulations and differences between electronic and paper trading systems.