The majority of investors purchase and retain stocks in order to profit off long-term growth, thus giving the name to a "long" position. Once purchases have settled, the stocks owned increase and there is reduced cash in the investor's account. 

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The opposite occurs when the investor sells stocks. However, traders also need the ability to short sell a stock, meaning they must sell a stock without already owning it. 

Who short sells stocks?

For market efficiency, it's important to have the ability to short sell a stock. There are many good reasons to short sell:

 

Short selling maintains swaps, futures, ETFs, and options at a fair price. A liquidity provider needs the ability to short sell a stock in order to hedge a bid in the derivative. By doing that, their long derivative position and short stock is a riskless hedge.

 

Market makers who provide tight bids and offers on corporate stocks also potentially end up selling to a buyers at net value.  

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Until short-term imbalances return to normal, long short portfolios and statistical arbitrage may need to be long one stock and short another, at times for days or even weeks.

 

Data shows that a small percentage of investors also run established short portfolios, with the aim to short sell stocks which they expect to underperform.

 

Short selling research studies demonstrates that it helps optimize market efficiency by reducing derivative mispricing and trading costs, adding liquidity, and improving single-stocks price discovery. Research also implies that short sellers have less impact on stocks than long sellers. 

How can you short sell?

The aim of market rules is minimizing  failed trades. Before initiating a short sale, traders must firstly "borrow" the stock from its long-term holder, seeing as a short seller doesn't already own the stock. 

How trades are typically settled

>Buying a stock

Stocks possess a mature stock loan market. 

As it happens, many long portfolios reap the benefits of fees earned as a result of loaning their stock. Often this will help investors to minimize their portfolio management expenses. To protect the stock-loaning owner from credit risks, loans are over-collaterized and if needed, additional margins are called.

How short sales are settled

>Shorting a stock

The term "short squeeze" signifies that a stock's price increases. It is possible for short squeezes to occur when shorts take losses after a stock rallies, instead of losing value and potentially triggering margin calls. To close a short means to buy stock and return the stock-loaned to investors. 

>How shorted is the average stock?

Interesting insights can be provided by observing short interest across stocks. Both mega-cap stocks and nano-gap stocks have fairly low short interest, while mid-cap stocks usually have significantly  higher short interest. 

This data appears to show that most short interest isn't accounted for by hedges for future (S&P500 futures possess the most liquidity). However, additional short interest may be contributed to by EFTs such as the Russell 2000 ETF, IWM, which trades $4 billion on a daily basis. 

 

Average short interest by market cap

>Average short interest as % shares outstanding; viewing shorts by ticker

By viewing short interest as a percentage of outstanding shares for each stock, we can observe an ample range of short interest around those averages. Just 11% of stocks are over 10% short, compared to the much larger percentage of 27% which are under 1% short. This is also the case for micro-cap stocks and could be an indicator that for many of those stocks, stock loans are less available. 

Short interest by ticker and stock price

Across stock price the trends are mostly flat, with the R-squared of each market cap group being under 1%. To sum it up, stock price has no influence on the attractiveness of a stock to shorts.

It is also interesting to observe the group of stocks with a price of $10. Many of them are SPACs (special purpose acquisition companies) which are akin to private equity vehicles with dry-powder for acquisitions. These only hold cash and usually have a price of $10, meaning their valuation typically holds until the announcement of an acquisition. 

 

>So what does this mean?

Shorts are feared by many issuers, which is logical; shorts don't simply sell stocks, occasionally they do it expecting the price will fall. However, there could be less to fear than you think. Of major strategies tracked by HFRI, it is shown that the lowest returns are held by short biased hedge funds.

Hedge fund strategies which short sell are leading the pack

HFRI's decade-long core strategies performance  There are fairly few stocks with high proportions of shares shorted, as well as guardrails limiting short sellers' positions, especially, as we observed in the recent selloff triggered by COVID-19, when stock prices fall. Shorts mostly help provide buyers with tighter spreads, as well as helping to make derivates more efficient. They also offset single stock demands by pulling liquidity from the wider market. 


Overall, short selling is a vital part of the market's system for investors, although you may dislike it when it's your stock being sold.

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