Short Selling Myths: Separating Fact from Fiction

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Written By
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Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.

Every now and then, short selling is top of mind in the financial media, whether from the optics of some people making money during a bad market downturn, management teams complaining about short sellers (e.g., Tesla/Elon Musk), or speculative manias in meme stocks like Gamestop and AMC. 

There are many widespread misconceptions of short selling and myths/conspiracies that were highlighted during the Gamestop and AMC meme stock sagas.

We’ll briefly go through each. 


Myth #1: It’s illegal to short more than 100 percent of the float

It’s not. A single share can be lent out multiple times. Each share sold short creates an offsetting long share in the float (for every seller there’s a buyer). 

For example, let’s say a company has 100 shares outstanding. A owns 90, B owns 10. 

A lends its 90 shares to C, who then shorts them to D (i.e., D buys). A owns 90 shares, B owns 10, and D owns 90. 

Adding all of those up (90+10+90), 190 shares show up in terms of total ownership and 100 shares are outstanding. In other words, the float increases and the number of shares outstanding stays the same. 

This balances out because there’s 90 shares lent out – i.e., C owes 90 shares to A at a point in the future. It’s not any different from a loan – debt is a “short money” position. It eventually has to be paid back, usually with interest, just like in stock lending. 

Nominal short interest is expressed as 90/100 (90 percent), though effectively it’s more like 47 percent because it’s 90 shares out of 190 total in the float. 

D can lend 90 shares to E. E shorts them to F. 

Now we have A owning 90, B 10, D 90, and F 90, for a float of 280. Short interest is 180 of 100 outstanding shares or ostensibly 180 percent. But it’s effectively 64 percent (180 divided by 280). 

In other words, the shares can just be reborrowed over and over again. F can lend out to G, and so on and so forth. 

There’s nothing illegal or nefarious going on when the nominal short float is in excess of 100 percent. 


Myth #2: Naked shorting is unethical and/or illegal

Naked shorting occurs when someone who is short a stock fails to deliver its obligation to the buyer. This is illegal to do intentionally, but is rare. 

When failing to deliver occurs, their broker will tell them to fix the situation. There’s a lot of legal risk for no gain.


Myth #3: It was David vs. Goliath, Main Street vs. Wall Street

No, it was initially fueled by social media. It went viral and made its way beyond Reddit and other social media to the mainstream press. There was some short covering by hedge funds, but only a select few.

Hedge funds are not a big part of the asset management industry at about only $3 trillion. The asset management industry is over $40 trillion just taking the US by itself. 

“Wall Street” – which is typically used as a metonym to refer to the financial industry as a whole – also includes investment banks, brokers, lenders, other asset management companies (e.g., mutual funds, passive managers), and other types of financial firms. 

Many of those companies made a lot based on being long those stocks, selling volatility, making those markets (reducing bid-ask differentials), lending, collecting commissions, and similar activities. 

Some people may have lost a lot and won a lot on each side of the trade and every strategy in between. But that happens all the time every day in all sorts of markets. Shorts may have lost in the short run and longs who bought the stock at high levels, especially on leverage, will also lose a lot.

The little guy vs. big guy narrative sells well, but it’s a myth. 


Myth #4: Shorting hurts a company and can drive it to bankruptcy

Companies go bankrupt because they can’t pay their liabilities. It’s never because short sellers drove the price down of the stock down. 

The assets and liabilities on a balance sheet don’t have much to do with where the public markets have the equity pegged on a mark-to-market basis.

The stock price is largely immaterial to most public companies the vast majority of the time. Most of the world’s companies are also not public, but private. They don’t have shares that are priced continuously during certain hours of the week. Yet they continue to operate just fine.

Public company management teams tend to care a lot about their share price, as it often has to do with how they’re compensated. So, while it’s still somewhat rare for management teams to publicly complain about short sellers, it does happen. 

Tesla CEO Elon Musk has frequently complained about short sellers, even going so far to threaten legal action against a Seeking Alpha blogger under the pseudonym Montana Skeptic if he didn’t cease writing negative commentary about the company. 

Wirecard and Enron often blamed their problems on short sellers and the “fear, uncertainty, and doubt” (FUD) they bring. But they were fundamentally weak companies that ultimately weren’t worth anything.

What about raising money?

If short selling genuinely created an undervalued stock price, investors would come in to buy it.

Many companies can raise debt instead of equity. It’s cheaper because it’s senior in the capital structure and lenders are paid out before shareholders. And debt doesn’t dilute ownership.

Lenders look at assets, liabilities, incomes, and expenses to determine whether any entity is worth lending to. Shareholders care about the same things. But they may not care about near-term cash flow like a lender might. This is because shareholders expect more in return over time.

Short sellers that have fundamentals-based reasons for shorting a stock are also not going to short companies that are healthy and fairly priced (or undervalued).


Myth #5: Robinhood and other brokers stopped accepting orders to protect hedge funds

No. US stocks are settled on what’s called a T+2 basis. This means they’re settled two days after the transaction is made.

Because of this, there is a series of credit exchanges between buyers and sellers, their brokers, and the central clearinghouse (in this case DTCC), which is essentially like a broker of the broker. 

DTCC sets a margin requirement for the brokers under its umbrella. Margin is partially based on implied volatility of the underlying security. Gamestop (GME) had implied volatility north of 500 percent during the peak of its frenzy, which is massive. DTCC accordingly had to up its margin on that stock to 100 percent. 

Brokers, in turn, had to cut their risk down on the risk dramatically.


Myth #6: DTCC only raised margin requirements for Robinhood

No, it was raised for all DTCC clients that had trades to settle for the equities affected.

Interactive Brokers and E-trade were two other firms (among many others) that were forced to limit GME to closing-only orders during peak volatility. 

Robinhood was the most affected because of the volume being traded in these securities.