Short selling

Short selling allows hedge fund managers to make money when stock prices go down. This strategy is one of the key differences between hedge funds and traditional mutual funds, which typically only profit when prices rise.

Here's how short selling works: A hedge fund borrows shares of a stock from a lender, usually through a prime broker. The fund immediately sells those borrowed shares in the market and receives cash. The fund hopes the stock price will fall. If it does, the fund can buy back the shares at the lower price, return them to the lender, and keep the difference as profit.

For example, if a fund borrows 100 shares of Company X trading at $50 per share, it receives $5,000 from selling those shares. If the stock drops to $40, the fund can buy back the 100 shares for $4,000, return them to the lender, and keep the $1,000 profit (minus borrowing costs and fees).

Short selling depends entirely on the ability to borrow securities. Prime brokersA financial institution that provides comprehensive services to hedge funds including trade execution, custody, securities lending, margin financing, and capital introduction. serve as intermediaries, lending securities to hedge funds to enable short sales. The availability of securities for borrowing varies significantly based on market demand and supply.

Some securities are "hard to borrow," meaning they are expensive or difficult to obtain for short selling. This scarcity can make short selling strategies more costly or even impossible for certain stocks. Many hedge funds maintain relationships with multiple prime brokers specifically to expand their access to diverse securities inventories for borrowing.

When direct physical borrowing is impractical or when hard-to-borrow securities create excessive costs, some prime brokers offer synthetic or derivative-based products. These products provide short exposure without requiring the actual borrowing of physical shares.

The Securities and Exchange Commission (SEC) has created extensive rules governing short selling activities. The main regulatory framework is called Regulation SHO SEC Regulation SHO Regulation SHO is the SEC's comprehensive set of rules that governs how short selling works in U.S. stock markets. The regulation requires that short sellers locate shares before selling them short, sets deadlines for delivering those shares, and establishes specific requirements for how orders must be marked and when trading restrictions apply. Hedge funds and other market participants who engage in short selling must follow these rules. , which establishes comprehensive rules about how short sales must be executed and reported.

One of the most important parts of this framework is the "locate requirement." This rule prevents broker-dealers from accepting short sale orders unless they have already borrowed the relevant security or have a reasonable basis to believe they can obtain it by the settlement date. This prevents "naked" short selling, where someone sells shares they haven't actually borrowed.

Additionally, Exchange Act Rule 10b-21 creates legal liability for short sellers who make false statements about their ability or intention to deliver securities on time and then fail to do so. This rule applies not only to broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. but also to investment advisers, who can face penalties for fraudulent conduct related to short sale failures.

Regulation SHO has four main components that work together to regulate short selling:

First, order-marking rulesRegulatory requirements under Regulation SHO that mandate all stock sales be labeled as 'long,' 'short,' or 'short exempt' to track short selling activity and prevent improper naked short sales. under Exchange Act Rule 200 require all trades to be properly labeled.

Second, the locate requirement under Exchange Act Rule 203 ensures shares are available for borrowing.

Third, a short sale price test circuit breakerAn automatic trading restriction in Regulation SHO that limits short selling when a security's price declines at least 10 percent from the previous trading day's closing price. under Exchange Act Rule 201 restricts short selling during sharp price declines.

Fourth, close-out requirementsRegulatory obligations under Regulation SHO requiring that failed securities deliveries be resolved and closed within a specified timeframe to prevent prolonged settlement failures. under Exchange Act Rule 204 mandate that failed trades be resolved quickly.

While these Regulation SHO rules directly apply only to broker-dealers, hedge funds still must follow them. Most brokerage agreements require the fund or its adviser to comply with marking and delivery obligations as part of their contract. For this reason, hedge fund managers must maintain strong systems to ensure their broker-dealers receive accurate position and trading information.

Every stock sale must be marked with one of three labels: "long," "short," or "short exempt." A sale can only be marked as "long" if the seller actually owns the stock and maintains a net long positionA situation where an investor's total long holdings in a security exceed their total short holdings across all accounts and trading venues combined. at the time of the sale.

To determine whether a position is net long or short, market participants must combine all their holdings in that stock across all accounts and trading venues. This aggregation requirement creates complexity for hedge funds that manage multiple prime broker accounts.

For instance, suppose a fund has a long position of 10,000 shares with Prime Broker A and a short position of 10,000 shares with Prime Broker B. Even though the fund holds actual shares with Prime Broker A, its net position across both accounts is zero. Therefore, any sale order must be marked as "short" rather than "long," despite the fund owning physical shares.

This requirement means hedge funds must calculate their global position across all accounts before determining how to mark individual sale orders.

Regulation SHO includes automatic restrictions designed to prevent excessive short selling during sharp price declines. When a stock's price falls at least 10 percent from the previous day's closing price, special rules kick in to limit further short selling pressure.

This 10 percent threshold applies to all stocks listed on national securities exchanges, whether they trade on an exchange or over-the-counter. Once the threshold is crossed, trading centers must enforce a price restriction. This restriction prevents short sales at or below the current national best bid for the remainder of that trading day and the following trading day.

The SEC has provided narrow exemptions for certain types of transactions. These include trades by market makers managing odd-lot positionsHoldings in securities where the number of shares is less than a round lot (typically fewer than 100 shares), often managed separately by market makers., underwriters conducting distribution activities, and traders executing qualified arbitrage strategiesSpecific trading strategies involving simultaneous purchase and sale of related securities to capture price differentials, qualifying for exemptions from short sale restrictions under Regulation SHO.. However, these exemptions are limited and require specific conditions to be met.

Since 2025, hedge fund managers and other institutional investment managers face new transparency obligations regarding their short positions. The SEC adopted Rule 13f-2SEC rule requiring institutional investment managers to file monthly reports disclosing short positions exceeding specified thresholds, adopted in 2023 to increase transparency in short selling activity. and Form SHOThe SEC reporting form that institutional investment managers must file monthly to disclose gross short positions in equity securities exceeding specified dollar or percentage thresholds. in October 2023, creating monthly reporting requirements for short positions.

Form SHO filings are due within 14 calendar days after the end of each calendar month for equity securities where the manager holds short positions exceeding specific thresholds. The thresholds depend on whether the company is publicly reporting or not.

For publicly reporting company securities, managers must file if they hold a monthly average gross short positionThe total value or percentage of short positions held in a security during a reporting period, calculated without netting against long positions in the same security. of either $10 million or more, or 2.5 percent or more of the company's outstanding shares. For non-reporting company securities, the threshold is a gross short position of $500,000 or more at any point during the calendar month.

These reporting requirements apply to hedge fund advisers exercising investment discretionThe authority granted to an investment manager to make trading decisions on behalf of clients without obtaining prior approval for each transaction. over fund accounts. They represent a significant new compliance obligation that requires tracking short activity across all fund portfolios. The SEC aggregates the reported data and publishes summaries to provide regulators and market participants with enhanced visibility into short selling patterns.

Short selling creates unique risks that hedge funds must carefully manage. The most significant difference from long positions is that short selling carries theoretically unlimited loss potential. While long positions can only lose the initial investment (if the stock goes to zero), short positions can lose infinite amounts since stock prices can rise indefinitely.

Additionally, short sellers must pay borrowing costs to the security lender during the entire borrowing period. They must also pay any dividends that the stock distributes while they hold the short position. These costs can significantly affect the profitability of short positions over time, especially for dividend-paying stocks.

Hedge fund managers must also integrate the operational requirements under Regulation SHO and the new Form SHO reporting obligations into their trading operations and systems infrastructure. This includes maintaining accurate position tracking across multiple accounts and ensuring compliance with marking and delivery requirements.