A coordinated group of Reddit traders pushed GameStop stock from $17.25 to over $347 in less than a month in January 2021. Hedge funds with short positions lost billions in the squeeze.
For financial advisors, short selling is one of the most discussed and least understood strategies in the market. This guide walks through how short selling works, who uses it, what it costs, and what regulators require.
Short selling gives financial advisors a way to profit from falling stock prices or protect client portfolios when markets turn lower. It’s one of the few strategies that pays off when a stock drops, which makes it useful for both speculation and hedging.
“Short selling involves borrowing shares and selling them with the intention of repurchasing them later at a lower price before returning them to the lender,” explains Jim Overdahl, partner at Delta Strategy Group and former SEC chief economist.
“A short seller either believes that a stock is overvalued and will decline in price or uses a short position to hedge other parts of their portfolio.”
The first motivation is speculation. The second is risk management. Speculative short sellers don’t pick targets at random. They build a case by valuing the company on its own merits and comparing that figure to the share price.
“Short sellers who believe that a stock is overvalued typically arrive at that view by comparing their estimate of a stock’s fair value to the current market price,” Overdahl says. “If correct, the short seller profits by selling borrowed shares at a high price and repurchasing – or ‘covering’ – them at a lower price, with the difference representing the trader’s profit.
“However, if the share price rises instead, the short position generates a loss, since the trader must repurchase shares at a price higher than the original sale price.”
Short selling looks straightforward, but the execution involves several steps that need to happen in the right order. Skip one or get it wrong, and the trade can trigger penalties, margin calls, or a forced position closure.
Behind the scenes, short selling depends on the securities lending market. Prime brokers source the shares from institutional lenders such as pension funds, mutual funds, and university endowments. This relationship is what gives hedge funds and large RIAs reliable access to borrowed shares.
For a list of firms recognized for advisor capability, check out our special report on the top RIA firms in the US.
Every short selling trade has two possible endings. Here’s how a single trade plays out, first when it works, and then when it doesn’t.
A trader believes XYZ stock, currently trading at $50, will fall over the next three months. They borrow 100 shares and sell them on the open market for $5,000.
A few weeks later, XYZ reports weak quarterly earnings, and the price drops to $40. The trader buys back 100 shares for $4,000 and returns them to the lender. The profit, before margin interest and borrowing fees, is $1,000.
Same setup, but the trader holds the position too long. A competitor announces a takeover bid for XYZ at $65 per share, and the stock rises sharply.
The trader has to cover at the higher price. Buying back 100 shares at $65 costs $6,500, and the loss on the trade is $1,500. In theory, there’s no ceiling on how high the stock could have gone before the trader closed the position.
Short sellers exposed accounting fraud at Wirecard in April 2020, and the stock dropped 26 percent after a special audit. Jim Chanos famously shorted Enron in 2001 before the company collapsed. Both companies appear on our list of biggest investment frauds in recent history.
For RIAs and financial advisors, the decision to short isn’t usually about conviction. It’s about infrastructure.
“Short selling is rarely used in traditional mutual funds but is common in hedge funds, which face fewer regulatory constraints and typically have prime brokerage relationships that provide ready access to securities lending,” Overdahl says.
He adds that advisors and RIAs who do use short selling tend to apply it in one of three ways:
“Beyond equities, some strategies, such as global macro funds, use short positions in currencies, sovereign debt, commodities, or equity indices based on macroeconomic views,” Overdahl says.
The use case extends to other parts of the market structure. Convertible bond arbitrage strategies depend on short selling to hedge the equity component of the bond. Market makers, who account for roughly 35 percent of all short sales, also use short positions to manage inventory and tighten bid-ask spreads.
InvestmentNews looks at how short selling fits inside a fund product in this interview with Wayne Penello, CEO and founder of NextGenEMP.
For more on alternatives in advisor portfolios, visit and bookmark our section on alternative investments.
Short selling carries the rare feature of unlimited loss potential. A long position can only lose what was invested. A short position, on the other hand, can lose multiples of the initial trade value if the stock keeps rising. This is why advisors who use it actively monitor margin levels, dividend dates, and recall notices from the lender.
According to Overdahl, the practice carries six core risks:
FT Film documented the GameStop short squeeze in this longer-form look at how Reddit traders took on the hedge funds shorting the stock.
For a list of vetted planners who can help clients evaluate whether short selling fits their portfolio, see our best financial planners in the US special report.
The SEC regulates short selling under authority granted by the Securities Exchange Act of 1934. The framework has tightened in recent years. Advisors who use the strategy need to track three rules in particular.
This is the principal rule book. It requires brokers to mark orders as long or short, applies the alternative uptick rule, which restricts shorting after a stock falls 10 percent in a day. The rule also forces brokers to locate borrowable shares before any short sale and mandates close-outs when delivery fails.
Selling shares without first borrowing or arranging to borrow them is banned. Regulation SHO’s locate requirement is what enforces this in practice.
Finalized in October 2023, the rule requires securities lenders to report the material terms of lending transactions to FINRA. Reporting through FINRA’s Securities Lending and Transparency Engine, or SLATE, is now set to begin September 28, 2028, after two extensions.
The rule has also faced legal challenge. In August 2025, the US Court of Appeals for the Fifth Circuit remanded it to the SEC for further economic analysis but did not vacate it.
Short selling can hedge a long portfolio, surface fraud, or generate alpha. It can also produce unlimited losses, trigger margin calls, and force a position close at the worst possible moment. Advisors with the prime brokerage infrastructure to use it well have a tool. Those without it have a risk. Reading the difference is the advisor’s job.
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