The Mechanics and Risks of Short Selling — The Possibility of Unlimited Loss

Short selling is a trade that bets on a stock price decline. The order goes like this.

(1) Borrow someone else's stock (a securities loan). (2) Sell it in the market now. (3) Later, when the price falls, buy it back cheap. (4) Return the repurchased stock and keep the difference.

For example, if you borrow and sell at about $74 and buy back to return at about $52, the gain is about $22 (excluding fees and costs). It's a structure that profits the more the price falls.

To short, you must first borrow the stock, so a securities loan and a lending fee always come attached.

The most important feature of short selling is that there is no cap on losses.

With an ordinary purchase, at worst the price goes to 0 and -100% is the limit. You lose only the money you put in.

But short selling is the opposite. In theory a stock price can rise infinitely. If you sold at about $74 and it becomes $220 or $370, you have to buy it back at that price to return it, so losses can swell to several times your principal.

In other words, it's an asymmetric structure of 'limited profit (down to a price of 0), unlimited loss.' It is the exact opposite shape to the risk of buying.

The classic case where unlimited loss became reality is the GameStop (GME) episode of January 2021.

Several hedge funds bet on a GME decline through short selling, but when retail investors banded together online and bought the stock en masse, the price surged. GME jumped about 400% in a single week in January, and about 1,625% from the start of the year.

The short sellers rushed to buy back the rising stock (short covering) to stem losses, but that buying pushed the price even higher, producing a 'short squeeze.' Notably, Melvin Capital lost about -53% in the single month of January (its roughly $12.5 billion of assets under management at the start of the year plunged, with $2.75 billion injected from outside).

Short selling has a positive function of deflating bubbles in overvalued assets and aiding price discovery. That is why it is institutionally permitted.

But for individuals it is very dangerous, with unlimited loss, lending fees, short squeeze risk, and repayment pressure all combined. In Korea, individual access to short selling is limited, and it has been temporarily banned in the past during periods of sharp market swings.

This service looks at 'if you hold good assets for a long time, how much?' The first step is to clearly understand that short selling is a short, dangerous bet on a decline on the opposite side of that.