Short selling: how does it actually work? The complete guide

In January 2021, GameStop shares went from about $17 to an intraday high of $483 on 28 January. According to data published at the time, short positions exceeded 100% of the shares in circulation. The hedge fund Melvin Capital, heavily exposed to a fall, lost more than half of its assets in a month and needed a $2.75 billion recapitalisation.

Short selling has a bad reputation, yet it sits at the heart of how markets work: it lets investors hedge, corrects valuation excesses and makes money when an asset falls. Here is how it works, what it costs and how to avoid the traps that cost Melvin Capital so dearly.

Short selling: the 2-minute refresher

Short selling, or "shorting", means selling a borrowed asset today in the hope of buying it back later at a lower price. Your gain is the difference between the selling price and the buyback price.

How a short sale works

The mechanism has three stages.

1. The borrow: your broker borrows the shares, from its own inventory or from another investor who lends them for a fee.
2. The sale: the borrowed shares are sold at the market price. You receive the proceeds, which stay locked as collateral.
3. The buyback: later, you buy back the same number of shares and return them to the lender. The position is closed.

Example: you short 10 shares at €100.

Simplified examples, excluding borrowing fees and dividends.

A price cannot fall below zero, so your maximum gain is €1,000. A price can, however, rise without limit, and so can your loss.

When you buy, you risk at most your stake. When you short, you risk more than your stake.

What a short position costs

A short is not free to hold. Three costs build up over time.

Borrowing fees. For most large, easy-to-borrow stocks, they run at around 0.25 to 1% a year. For a heavily shorted or scarce stock, they can exceed 20% or even 50% a year.

Dividends. If the company pays a dividend while you are short, you must pay it to the lender of the shares.

Financing. Depending on the product used (securities lending, CFD, futures), a daily financing cost may apply.

Example: a €5,000 short on a stock held for 6 months.

Calculation: €5,000 × annual rate × 0.5 year. Dividend assumed at 2% of the share price.

In the second case, the price has to fall 15% in six months just to cover the costs.

Time works against the short seller.

Shorting and leverage: a mix to handle with care

On most platforms, a short position is opened on margin: you post collateral worth less than the position. Leverage then multiplies the result, in both directions.

Example: you want to short €5,000 of an ETF with €1,000 of capital.

Simplified examples, excluding fees.

With 5x leverage, a 20% rise wipes out all the capital committed. Platforms generally close the position before that point, at the minimum margin level required.

A highly leveraged short does not need to be wrong for long to lose.

Shorting to speculate or to hedge

Short selling serves two very different purposes.

Speculation: you think an asset is overvalued and you bet on its fall.

Hedging: you hold a portfolio and want to protect it temporarily without selling it. For example, you own €20,000 of US stocks and fear a fall ahead of an earnings release. You short €10,000 of an S&P 500 ETF for two weeks.

Simplified examples, excluding fees. The hedge is only perfect if the portfolio tracks the index.

Here the hedge halves the risk, in exchange for part of the upside. This is the principle behind the long/short strategies used by many funds.

Hedging is not betting against the market, it is paying for insurance.

Real-world case: GameStop, January 2021

At the end of 2020, GameStop was one of the most shorted stocks in the United States, with short interest estimated at more than 100% of the free float. Retail investors, coordinating on the Reddit forum WallStreetBets, bought the stock and call options in large volumes.

The rise forced short sellers to buy back to limit their losses, and those purchases pushed the price even higher. The stock went from about $17 in early January to $483 intraday on 28 January 2021. Melvin Capital lost about 53% in January and received $2.75 billion from Citadel and Point72 to keep operating. The fund closed in 2022.

Two lessons

• A crowded short is dangerous even when the analysis is right: buyers only need to outnumber sellers for a few days.
• Short interest is worth watching. Above 20 to 30% of the free float, the risk of a squeeze becomes serious.

Advantages of short selling

• Profiting from a fall: you can benefit from a bear market instead of just waiting it out.
• Hedging a portfolio: you reduce your exposure without selling your holdings or triggering tax.
• Expressing a relative view: by combining long and short, you bet on the gap between two assets.
• Contributing to market efficiency: short sellers have exposed several frauds, including Wirecard in Germany.
• Flexibility: the position can be closed at any time during market hours.

Drawbacks and risks

• Unlimited theoretical loss: a price can rise with no ceiling.
• Short squeeze: cascading buybacks can trigger a sharp and irrational rise.
• Carrying cost: borrowing fees and dividends eat into the gain day after day.
• Upward bias of markets: over the long run, major equity indices tend to rise.
• Leverage: a margin position can be liquidated before your scenario plays out.
• Regulatory restrictions: regulators can temporarily ban short selling in a crisis, as France did in March 2020.

Short, put, inverse ETF: three ways to play a fall

Why investors choose Neverless

Long and short in the same app: you can go long or short on stocks, ETFs, crypto, gold and silver.

Leverage you choose: up to 5x, which you can also leave at 1x for a short with no multiplier.

No commission on orders: opening, reducing or closing a position costs no brokerage fees.

A regulated framework: Neverless is licensed under MiCA and MiFID II.

No platform makes a short risk-free. What Neverless does is give you the tools to size it and monitor it.

Short selling carries a high risk of capital loss, which can exceed the initial stake when leverage is used. This article is educational and does not constitute investment advice.