Short Selling

Short selling is the sale of borrowed shares. The trader borrows stock through a brokerage, sells it at the market price, and hopes to buy it back later at a lower price. The borrowed shares go back to the lender, and the difference is the profit. Profit is capped: a stock can only fall to zero, so the maximum gain on a short is 100% of the position. Losses are not capped: a stock can rise without limit, and every point above the sale price is a dollar owed.

The mechanics require a margin account, because borrowing securities is borrowing money's cousin. Regulation T requires 50% initial margin. FINRA sets a 25% minimum maintenance requirement that brokers raise for shorts, often to 30% or more. The short also pays any dividends the stock issues to the lender. The borrow fee ranges from fractions of a percent on easy-to-borrow names to double digits on hard-to-borrow ones.

The trade runs in four moves. Locate and borrow the shares through the broker, sell them at the market, and let the proceeds sit as collateral. Wait, then buy to cover at the lower price and return the shares to the lender. A short of 100 shares at $100 covered at $75 pockets $2,500, which is 50% on the $5,000 of collateral posted, before borrow fees and margin interest.

The margin math is where shorts differ from longs. Regulation T requires 50% initial margin: short $10,000 of stock and post $5,000 of equity. If the stock rises to $150, the position has lost $5,000, the equity is gone, and the broker issues a margin call requiring a deposit. Brokers set maintenance requirements for shorts well above the FINRA minimum, often 30 to 40%, and the requirement rises as the price does, because the lender's collateral is shrinking while the position's risk grows.

The squeeze is the tail risk. GameStop in January 2021 is the reference case: short interest exceeded the entire float, the stock ran from about $20 to an intraday $483, and shorts who were right about the business were still liquidated on the route. A short can be correct about the destination and bankrupted by the journey, because there is no deadline on how long a price can disagree with you.

Short selling is the market's price-discovery mechanism and the retail trader's most asymmetric bet. The asymmetry runs the wrong way. Gains cap at 100%; losses do not, and the carry is negative: borrow fees, margin interest, and dividends paid to the lender are due every month the thesis takes to work.

I watched a colleague named Brent (yes, that Brent) short a retailer at $30 with a full position because its short interest was elevated and the chart looked tired. The earnings beat, the stock squeezed to $60, and the margin call asked for a deposit roughly the size of his original stake. He covered at the top of the pain and the stock rolled over a month later; the destination was right and the route was fatal.

The highest-leverage thing most Americans can do is skip shorts in retirement accounts, where brokers do not allow them. Size any taxable short as a fraction of a long position, with a hard stop attached. Weigh the asymmetry with the risk reward calculator and size it with the position size calculator.