The environment for short sellers on Wall Street has grown tougher, leading many prominent figures to scale back or exit.
Jim Chanos, famous for predicting Enron’s collapse, converted his hedge fund into a family office last year. This move came as the investing titan cited dwindling assets under management, with this figure dropping from over $6 billion in 2008 to less than $200 million today. This decline mirrors the broader industry trend, with assets in short-biased funds falling to $4.6 billion from $7.8 billion in 2008 and the number of activist campaigns hitting a decade-low in 2022.
Andrew Left of Citron Research (another prominent short-selling firm) recently called short selling “a bad business” due to constant legal and regulatory challenges, and the HFR Short-Bias Hedge Fund Index has decreased from 54 members in 2008 to just 14 today.
With that said, let’s dive into what short selling is and why risks are increasing.
What Is Short Selling?
Selling a stock short involves a process that can seem daunting to understand at first, but it’s really not. Essentially, investors borrow shares of a given company they want to bet against. They sell those shares in the open market to those who believe the stock will go up and promise to buy the shares back (and return them to the brokerage/investor they borrowed them from) at some point in the future. In exchange for borrowing said shares, they agree to pay any dividends associated with the stock or index, as well as a cost-to-borrow fee.
This borrow fee can vary widely, depending on how volatile a stock is, and how in demand the stock is from short sellers. For highly-shorted stocks, this borrow fee rate can surge into the double or triple digits, meaning short sellers are forced to exit positions sooner. If a borrow fee rate is above 100%, it’s a guaranteed complete loss for an investor holding a short position for a year, assuming the rate doesn’t drop.
Additionally, unlike going long on a stock (simply buying shares), the risk is unlimited with short selling. Since the price of any security can go up to infinity (in theory), short sellers must time a trade right and have a much greater incentive to get out sooner. A short squeeze happens when a stock continues to climb, forcing short sellers to cover their trade (buy back shares en masse), driving the price of a highly-shorted stock much higher in the near term in a doom loop for short sellers.
Factors That Led to This Possible “Extinction”
The bull market hindered short sellers’ profits as the S&P 500’s capitalization rose by about $30 trillion over a decade, fueled by low borrowing costs and AI. JPMorgan (NYSE:JPM) strategist Nikolaos Panigirtzoglou noted this growth made short positions unsustainable. Median short interest in S&P 500 companies dropped to 1.7%, near a two-decade low.
Regulatory pressures increased, with the U.S. Justice Department and SEC investigating activist short sellers. Although no charges were filed, the SEC mandated monthly hedge fund reports on short positions, heightening scrutiny.
Globally, countries like China and South Korea also imposed short-selling restrictions.
Take a Lesson from GameStop Short Sellers
In recent headlines, a lot of short sellers have been buying into stocks that are obviously just rising due to hype. For example, GameStop (NYSE:GME), saw a stock surge due to Keith Gill, known better as Roaring Kitty, who has been rallying traders to buy GME stocks.
Gill posted on X for the first time since 2021, hinting at renewed interest. The meme stock craze saw individual investors target short sellers, forcing them to cover positions and drive up prices. Currently, over 24% of GameStop’s float is held in short positions, according to FactSet.
In May, GameStop short sellers incurred losses of $1.24 billion, according to S3. According to Ihor Dusaniwsky, these buy-to-cover schemes led to GME stock’s surge and attracted short sellers at $30.
On Monday, AMC Entertainment (NYSE:AMC) and Reddit (NYSE:RDDT) also saw some surge. Dusaniwsky warned of a challenging period ahead for short sellers in these stocks.
Bottom Line
When buying stocks (taking a long position), losses are capped at 100% of the investment. However, short selling has unlimited risk, as prices can keep rising. During a short squeeze, a heavily shorted stock’s unexpected rise forces short sellers to buy shares to cover their positions, driving prices even higher and amplifying losses for remaining short sellers.
Short selling fundamentally involves betting against companies or the market, which some investors oppose on principle. However, if convinced a stock will decline shorting allows acting on that belief, despite the risks involved.
On the date of publication, Chris MacDonald did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
