How Does Short Selling Work? What You Need to Know

Nasdaq Public Policy this month released a new <a href="https://www.nasdaq.com/public-policy/resource-center/short-selling-resource-hub">Short Selling Resource Hub</a>, which provides market participants with information they need to know about short selling – including the market data landscape and the regulatory protections that safeguard the securities market.

But even the basics of short selling are more complex than the typical buying and selling of securities. Read on for a primer on everything you need to know about how short selling works.

Why Does Short Selling Matter?

Short selling is one of the most misunderstood yet essential concepts in financial markets. Instead of the traditional approach to profiting in the market by buying low and selling high, short sellers reverse the process: they sell high first, then aim to buy back later at a lower price. This is typically done by borrowing shares, selling them on the open market, and eventually repurchasing them to return to the lender. If the price falls as expected, the short seller keeps the difference as profit; if it rises, they will record a loss.

Importantly, short selling is also used by market makers to provide intra-day liquidity and by investors to hedge positions in equities, futures, options and convertible securities.

Shorts sales play a crucial role in how markets function, including by enhancing price discovery, facilitating capital formation, and providing liquidity. Short sellers often act as a counterbalance to excessive optimism: Without short selling, markets could become more prone to bubbles, as there would be fewer mechanisms to identify and correct overvalued assets.

For anyone interested in the markets, short selling is more than just a sophisticated trading strategy: It is a lens through which to better understand markets and risk.

What is the Definition of Short Selling?

At its simplest, short selling is selling a security you don’t already own.

Short selling is a trading strategy used by investors to profit from or hedge against a stock price decrease. Unlike traditional investing, where you buy low and sell high, short selling involves selling borrowed shares at a high price with the goal of buying them back later at a lower price.

If the price of the stock falls, the short seller profits between the higher sale price and lower buy price.

Importantly, not all short sales are bets against a company. Short sales are used to hedge against long positions, options, futures, and convertible securities like bonds or warrants. Hedging is a risk management strategy that involves taking a position in one investment to offset a potential loss in another. Short sales are also used by market makers to provide liquidity to the market. For example, if a market maker sells put options to an investor, they gain positive exposure to the stock (similar to being long shares) and may short the underlying stock to maintain a neutral position.

Short selling is beneficial to markets by contributing to price discovery and market liquidity, ensuring stock prices reflect their true value faster.

How Short Selling Works: Step-by-Step

Short selling is selling shares that an investor does not yet own. In a typical short sale, an investor would:

1. Locate and Borrow: The investor identifies a stock or security and locates shares to borrow from a broker. Typically, investors borrow shares in the lending market through their brokerage firm. Lenders can be retail brokers or institutions such as index funds or ETFs, and they typically collect a fee for loaning stock. Stocks in large indexes like the Russell 3000 or S&P 1500 generally have more shares available for lending.
2. Sell: The borrowed shares are sold on the open market at the current price.
3. Deliver & Cover: The investor later buys the shares back (which they hope will be at a lower price) to return them to the lender. This "closing" of the position is called "buying to cover.”

The Risks of Short Selling

• Unlimited Loss Potential: In the normal process of purchasing equity shares, the worst that can happen is for the price to fall to zero, wiping out the full amount you paid for each share. With short selling, however, if the price of a stock keeps going up, the short seller could face mounting losses with no upper bound. In other words, if a short seller sells a borrowed share at $10, but the price rises to $500, they would then need to take a $490 loss to close out their position.
• Margin Requirements: Brokers typically require investors to maintain collateral in their account worth a certain percentage of the value of borrowed shares. Consequently, if the value of those shares were to suddenly rise, then the investor would need to add more money to their margin account to satisfy their broker’s requirements. If they cannot do so, a broker may close out the positions to bring the portfolio back within the required percentage.

Investor Protection and Market Safeguards

Certain rules and disclosure regimes already protect investors from manipulative short-selling, though none provide a complete snapshot of the short interest in a particular security.

Within the U.S., <a href="https://www.sec.gov/rules-regulations/staff-guidance/trading-markets-frequently-asked-questions-8">Regulation SHO (Reg SHO)</a> is a set of SEC rules designed to prevent "naked short selling." Reg SHO was adopted by the SEC in 2005 to address concerns regarding persistent failures to deliver and potentially abusive naked short selling.

Naked short selling occurs when a seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer on the settlement date. As a result, the seller fails to deliver securities to the buyer when delivery is due. Reg SHO requires brokers to have "reasonable grounds" to believe a stock can be borrowed before a short sale occurs. Bona fide market makers have an exemption to the locate rule.

Reg SHO addresses these and other concerns in the following way:

• Marking Requirements: Rule 200 of Reg SHO requires that a broker-dealer must correctly mark all sell orders of an equity security as either “long” or “short” (or “short exempt” in certain cases).
• Short Sale Price Test Circuit Breaker: Rule 201 of Reg SHO requires trading centers to temporarily restrict short sales when a given security has triggered a circuit breaker by having its price decrease by at least 10 percent in one day. In such a case, short selling of that stock is limited for the rest of that trading session and the next.
• Preventing Naked Shorting with “Locate” Requirement: Rule 203(b)(1) of Reg SHO requires that a broker-dealer can only accept a short sale order if they have “reasonable grounds” to believe that shares can be borrowed and “can be delivered on the date delivery is due.”
• Close-out Requirement: Rule 204 of Reg SHO requires that brokers and dealers deliver securities by settlement date and institutes close-out requirements for “failure to deliver positions.”

While data tends to show that very few people engage in naked shorting, public and private enforcement regimes act when it does occur:

• FINRA Enforcement: FINRA may bring enforcement actions against firms for failing to maintain a supervisory system reasonably designed to comply with Reg SHO, including the prohibition on naked shorting.
• SEC Enforcement: The SEC may bring enforcement actions against individuals and institutions for engaging in naked short selling.
• Criminal Charges: The DOJ may charge individuals and institutions with crimes, including securities or wire fraud, for engaging in fraudulent or manipulative trading that includes naked short selling.
• Private Lawsuits: Private plaintiffs, including issuers, may bring lawsuits against naked short sellers for market manipulation and securities fraud.
• Nasdaq Regulation: Nasdaq Regulation investigates market manipulation, including naked shorting, and may bring enforcement actions or refer the conduct to FINRA, the SEC, or U.S. Department of Justice (DOJ).

How Nasdaq Advocates for Short Selling Transparency

For more than a decade, Nasdaq has consistently supported enhanced transparency around short selling.

In a 2022 comment letter, Nasdaq supported proposed rulemaking to enhance transparency to investors and regulators by increasing publicly available short sale related data and advocated for disclosure where a market participant establishes a short position in a company and concurrently publishes, finances, or otherwise commissions negative research reports on that company.

Nasdaq’s 2025 white paper “<a href="https://www.nasdaq.com/Elevate">Advancing the U.S. Public Markets: Unlocking Capital Formation for a Stronger American Economy</a>,” recommended that the SEC require additional disclosure by short sellers in parity with the disclosure of long sellers and there should be increased transparency and accountability around short positions by market participants that publish negative research reports.

Frequently Asked Questions:

• Why is short selling good for the market? <a href="https://www.nasdaq.com/articles/deep-dive-how-short-selling-really-works">Academic research overwhelmingly shows</a> that short selling, on balance, benefits markets. Most research finds that the practice tightens spreads, increases liquidity, and improves the accuracy of valuations, especially after newsworthy events occur. Overall, that makes markets more efficient at allocating capital, reduces the costs of capital for companies and reduces trading costs for investors. Other research has shown that short-term bans on short selling do the opposite – reducing liquidity and widening spreads. Interestingly, studies also find no evidence that bans stop stock prices from falling. Importantly, one study found that during large price reversals, short selling is notably smaller than long selling. As a result, long selling was shown to affect stock prices more than short selling.
• What is a “short squeeze”? A short squeeze occurs when a stock or commodity’s price rises sharply, forcing investors with short positions to buy shares or contracts to cover their positions and limit losses, which in turn drives prices even higher and intensifies pressure on remaining short sellers.
• Who regulates short selling? In the U.S., short selling is primarily overseen by the SEC and FINRA, with exchanges like Nasdaq investigating potential manipulation.

Want to Learn More?

<a href="https://www.nasdaq.com/public-policy/resource-center/short-selling-resource-hub">Check out Nasdaq Public Policy’s Short Selling Resource Hub</a>, where investors and other market participants can find educational information on short selling, market data, and the regulatory protections that safeguard the securities market.