Short selling is a regulated and widely used strategy. Investors use short selling when they believe, based on fundamental research, that a stock price is overvalued.  Short selling promotes liquidity, stabilizes the market, and helps investors and companies reduce risk in their portfolios.

Some short sellers also conduct in-depth research and analysis that exposes financial fraud and corruption, such as the case in the Enron, Valeant, and Wirecard corporate corruption scandals. Additionally, short sellers correctly indicated the U.S. housing market was overvalued before the 2007-2008 financial crisis.

Regulators have long recognized the vital role of short selling to help markets function efficiently. The practice of short selling is well regulated and has oversight and transparency that allows the strategy to benefit a wide array of investors.

Securities laws give the SEC the authority to gain access to trading information and to prevent market manipulation. Permitting short selling, particularly with the current robust regulatory framework, means that investors can manage risks better and markets can factor in the broadest possible views about a particular stock, bond, or index – reducing the likelihood of bubbles forming.

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What is Short Selling?

How Short Selling Works

While widely used by active investors, short selling is commonly misunderstood. Traditionally, if an investor believes a particular stock will rise in value, they can purchase the stock, thus taking a “long” position. On the other hand, if an investor believes the price of a particular stock will go down based on fundamental research, they can “short” the stock.

Investors most commonly use “short” positions to express a view that a security, such as a stock, is overvalued.

When an investor “shorts” a stock, the following happens:

Graphic demonstrating the process of short selling. It includes icons representing the entities involved, including an Institutional Investor, Broker, Short Seller, and the marketplace. Arrows between the icons represent each step involved in the short sale process. The Institutional investor lends long positioned stocks to a broker. The broker lends 10 shares of ABC Stock to a short seller. Short seller sells 10 shares of ABC Stock for $500. The stock then loses value in the marketplace. The short seller then buys 10 shares of ABC Stock for $400 and returns the 10 shares of ABC stock to the broker, keeping $100. The $100 is received by the institutional investor as payment for lending the original long positioned stocks.

If the share price of the shorted stock goes down, the investor will receive a profit equal to the difference between the money they received when selling the borrowed shares and the cost of repurchasing the shares at a lower price.

If the share price rises, the investor will incur a loss as they will have to repurchase the shares at a higher price than the amount they received from selling the borrowed shares.

Short Selling Benefits Society, Markets, and People

Hedge funds may decide to short a stock for a variety of reasons. In some cases, they uncovered fraud or illicit business practices through highly sophisticated research. In fact, short sellers played a key role in uncovering fraud in the Enron, Wirecard, and Valeant scandals.

Enron Short Seller Detected Red Flags in Regulatory Filings

Wirecard shows why bans on short-selling are badly misguided.

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Short Sellers Don’t Exist to Fix the Problems. They Exist to Shed Light on the Problems.

In other cases, investors may take a short position because they believe a company’s management is not adapting to technological advances or emerging threats like climate change.

Hedge funds use short selling to deliver returns and shield their investors — including pensions, foundations, and endowments — from market volatility and asset bubbles. These same investors also earn money from lending securities to short sellers, boosting returns for their own investors.

As a result, short selling helps protect the retirement security of 26 million Americans, advance educational opportunities for tens of thousands of students, and support the missions of thousands of nonprofits across the country.

 

Public Pension Funds with the Most Securities Lending

In 2020, pension funds earned more than $1 billion from securities.

View the 20 public pension funds with the most securities lending in MFA’s Short Selling White Paper.

Illustration of the state of California

$75.7 million

California State Teachers’ Retirement System

Illustration of the state of Texas

$36.8 million

Teacher Retirement System of Texas

Illustration of the state of Wisconsin

$33.1 million

State of Wisconsin Investment Board

Short selling strengthens market integrity and delivers returns for institutional investors and those they serve.

Short selling is already well-regulated by the U.S. Securities and Exchange Commission (SEC), state regulators, and the U.S. Commodity Futures Trading Commission. Preserving short selling is essential to maintain the integrity of our financial markets and protect the millions of Americans who benefit from short selling.