Short Selling

Normally, you buy a security cheaply and sell it later at a higher price. A short sale reverses this order. The trader borrows shares from someone who owns them and immediately sells them on the exchange. Later, they must buy back the same number of shares and return them to the lender. If the price has fallen by then, they pay less on the repurchase than they received on the sale. The difference is their profit. The word “short” reflects the fact that they do not actually own the shares at the time of the sale.

Betting against a price

Short sales are the only common way to profit from falling prices. This gives them a function that goes beyond simply making money. If a stock seems overpriced, short sellers push the price down through their sales. Experts say this helps the market find a realistic price more quickly.

Some of the most famous fraud cases in economic history were uncovered by short sellers. These investors scour balance sheets for inconsistencies, then bet on a price decline and publish their research findings. In the case of the German payment services provider Wirecard, short sellers warned for years about fictitious bookings before the company collapsed in 2020. Financial regulators had even temporarily banned short selling of the stock – and were wrong to do so.

Nevertheless, short sales remain controversial. Critics accuse short sellers of amplifying panic and talking healthy companies into trouble. During crises, regulators therefore sometimes temporarily ban the practice, for example for bank stocks. Whether such bans actually help is disputed among economists.

Borrow, sell, buy back

The process has four steps. First, the trader borrows the shares, usually through their bank, from large funds or insurance companies. Second, they sell them on the market at the current price. Third, they wait. Fourth, they buy back the shares and return them to the lender. They pay a fee for the loan, similar to interest on a credit.

A numerical example makes this tangible. Someone borrows 100 shares and sells them at 50 euros each, totaling 5,000 euros. If the price falls to 30 euros, the repurchase costs 3,000 euros. That leaves 2,000 euros minus the loan fee. If the price rises to 80 euros instead, the repurchase costs 8,000 euros – a loss of 3,000 euros.

This is exactly where the big difference from a normal stock purchase lies. Anyone who buys a stock can lose at most their stake, since a price cannot fall below zero. With a short sale, there is no upper limit. The loss is theoretically unlimited. If the price rises sharply, the bank demands additional collateral or forcibly closes the position. If many short sellers have to buy back at the same time, they drive the price even higher. This escalation is called a short squeeze.

From GameStop to the disclosure lists

In the news, the term usually appears in two situations. Either a well-known investor publicly attacks a company, or a short bet goes spectacularly wrong. The most famous case is the US video game retail chain GameStop in January 2021. Retail investors coordinated in internet forums, bought the stock en masse, and triggered a short squeeze. Several hedge funds lost billions.

Short sales are no secret. In the EU, larger positions must be reported once they exceed a certain threshold. In Germany, they are listed in the Federal Gazette (Bundesanzeiger), viewable by anyone. Analysts use this to see which companies are under particular pressure.

This is also relevant for technology companies. With AI stocks that have risen sharply, there is regular debate about whether valuations are exaggerated. Short sellers then represent the counterpoint to general enthusiasm. For retail investors, however, this business is risky and in Germany only accessible through indirect means such as certain certificates.