Were all learning a lot about the mechanics of selling stocks short.

Recent events have thrust the practice of selling a stock short into the spotlight. With companies like GameStop (NYSE:GME) and AMC Entertainment Holdings seeing their shares soar as the result of short squeezes, everyones getting an education about the dynamics of short-selling and how it actually works.

In this latest short-selling controversy, many investors have been confused by the sheer level of exposure that short-sellers have to certain stocks. For instance, GameStop recently had short interest that exceeded 100% of its available shares. That left many investors completely gobsmacked -- but theres a simple explanation for how situations like the one were currently in can come about.

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Image source: Getty Images.

How to short a stock

If you want to sell a stock short, heres a simple guide to the process:

  • Go to your broker and find out if your target has shares available for you to borrow. If so, borrow the shares.
  • Take the shares that youve borrowed and sell them on the open market.
  • At some future date, buy back the shares, hopefully at a price thats cheaper than what it was when you sold the shares.
  • Pocket the difference if the stock has dropped since you sold it short, or find money elsewhere to make up the deficit if the shares got more expensive in the interim.

That sounds simple, but there are some facts to remember. If its hard for your broker to find shares that you can borrow, you may end up having to pay a borrowing charge to get the stock to sell short. The investor who loans you the shares has the right to get them back at any time with little notice. Ordinarily, your broker will find other shares that you can borrow in their place. If shares just arent available, the broker generally has the right to close your short position automatically.

Round and round shares go

At first glance, it might seem like you could never have more than 100% of a companys shares sold short. Once all the shares have been borrowed, you might think there wouldnt be any more for short-sellers to get.

Indeed, there are U.S. Securities and Exchange Commission regulations designed to prevent whats known as naked short selling. With a naked short sale, the broker allows the customer to do a short-sale transaction without actually arranging to borrow the shares beforehand. This can lead to market disruptions, and while there are some exceptions to the regulations, most brokers stop regular retail customers from selling stock short if they cant obtain shares to borrow.

However, even without a naked short sale, its theoretically possible for short interest to exceed 100%. The reason has to do with the nature of the short-sale transaction itself.

As an example, take a situation involving four investors. Annie owns shares of GameStop, and Annie and her broker have an agreement that allows the broker to lend Annies shares to short-sellers. It lends them to Bob, who subsequently sells those borrowed shares short in hopes that GameStops share price will fall.

An investor named Chris ends up buying those borrowed shares from Bob. However, Chris has no way of knowing that those shares have been borrowed from Annie. To Chris, theyre just like any other shares.

More importantly, if Chris has the same kind of agreement, then Chriss broker can lend out those shares to yet another investor. Diane, another GameStop bear, can borrow those shares and sell them short.

In this example, the same shares end up getting borrowed and sold twice. The short interest volume these transactions add to the total is twice the number of shares actually involved. You can therefore see that if this happened throughout the market, total short interest would eventually exceed the number of shares outstanding and approach 200%.

This still might seem impossible, and in a sense, it is. But part of the answer lies in the fact that there are investors that dont currently possess actual shares of GameStop but who have the same economic interest as shareholders. They have the right to get back the shares they lent at any time. When you add together the actual shares plus these synthetic positions in the stock, the short interest cant exceed 100% of that larger total.

The big risks of short sales

Given this ability to multiply the number of available shares into massive short positions, a short squeeze could have a cascade effect. When GameStops share price goes up, both Bob and Diane are under pressure to cover their positions. Yet to do so, they each have to find available shares they can buy and return to Annie and Chris, respectively. When sellers arent readily available, theyll have to pay through the nose to entice them. Thats how the short squeeze accelerates.

Add to that the fact that risks on short sales are potentially unlimited, and you can understand why so many people advise against short-selling at all. As crazy as the current stock market environment has been with stocks that are heavily sold short, the silver lining is that it will likely encourage millions of investors to avoid using this risky strategy in their own portfolios.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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