The Mechanics of Market Mayhem: Understanding Short Selling

From "The Big Short'' to the GameStop (GME) frenzy to South Korea's regulatory moves - what's the common thread? Each scenario is tied to short selling, a strategy that can cause turmoil in the financial markets.

Short selling involves borrowing a security and selling it, hoping to repurchase it later at a lower price, thus profiting from the difference. This approach is diametrically opposed to the typical investment strategy of buying low and selling high. Although short selling has been practiced since 1609, it gained notoriety during the stock market crash of 1929 and has recently surged in prevalence.

Michael Burry, renowned for his bet against the housing market in 2008, earned $1.6 billion for his hedge fund. However, he also faced significant unrealized losses during the time leading up to the Great Financial Crisis (GFC) because the market took longer to collapse than he predicted. The losses were exacerbated by margin loans used to establish short positions, magnifying the impact when the market moved against him.

In more recent events, stocks with a high short interest (where a large portion is sold short) have seen dramatic price increases due to short squeezes. GME in January 2021 is a case in point, with a short float exceeding 140%, indicating that more shares were shorted than were available. Retail investors pounced on this vulnerability, buying up GME shares and driving up the price. This forced short sellers to purchase shares to cover their positions and meet margin calls, further inflating the stock price.

Naked short selling, which played a role in the GME scenario, is selling shares that one does not own or have borrowed. This practice is why South Korea has prohibited short-selling until June 2024. Korean regulators are imposing the ban to prevent international institutional investors from skewing price discovery. During this hiatus, they aim to refine regulations and probe into the issue of naked short selling. The ban has sparked a rally in Korean indices, buoyed by restored confidence among retail investors.

Short selling has been a point of contention in the investment world, with figures like Warren Buffet criticizing it as "un-American." Nevertheless, it remains a fundamental aspect of trading. The pivotal question we face is: how much regulation is too much?

This is not investment advice.

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