Why Is Short Selling Legal?

When a stock rises, all of its investors turn a profit, right? That’s not the case for short-sellers, who look for profit by betting against the success of a company or the market. The recent events surrounding Tesla, Reddit, Robinhood and Gamestop’s short squeeze have put short selling under the limelight. So how did the practice of betting against the U.S. market become such a common, legal practice? Watch the video to find out. The recent events surrounding meme stocks and GameStop’s short squeeze have put short selling, one of the oldest practices in the stock market, directly under the limelight. “Short selling has always existed,” said Ihor Dusaniwsky, managing director at S3 Partners, a firm that specializes in analyzing short selling data. “It’s been a part of the normal trading process on the exchanges since exchanges started. We’ve seen short selling increase recently in a broader spectrum of names.” Short selling has always been a controversial practice, often blamed for causing drops in the market. The Securities and Exchange Commission eventually stepped in to better regulate short sales after short sellers were once again blamed for a market decline in 1937. “I think the main reason people dislike short selling is that something just feels bad about profiting from someone else’s failures,” said Sasha Indarte, an assistant professor of finance at the University of Pennsylvania’s Wharton School. “Short sellers gain when someone else loses. It’s like if you took out an insurance policy against your neighbor’s home and your neighbor’s home was destroyed.” Short selling is when investors, mostly professionals like hedge fund managers, borrow shares of a stock from a broker and sell them in the hope of buying them back cheaper. If the stock drops, the investors make a profit off the difference when they return the shares to the broker. A short squeeze occurs if the price goes up, and the investors need to rush to buy the stock to cut their losses. Countries in Asia and Europe have banned short selling during times of economic uncertainty. Some studies, however, have shown that a ban on short selling actually does more harm to the market than good. “During the financial crisis between 2007 and 2009, regulators have actually banned short selling temporarily in response to the large drops in the stock market. Regulators have since expressed that they regretted this policy action,” Indarte said.