First, let’s with what shorting a stock means. When you buy shares of a stock, it’s called going long. Shorting occurs when you sell more shares than you own. Since a stock’s price is determined by how many people want to buy a share vs. sell one, short selling increases the number of sellers and typically lowers a stock’s price.
An Increase in Sellers
When there is a high short interest in a stock (meaning a large percentage of the trading volume is people selling the stock short) this disrupts the balance between buyers and sellers. A stock’s price is determined by supply (selling) and demand (buying). More sellers mean there is more supply than demand. When supply outgrows demand, prices drop.
Short Selling Cycle
The drop in price only furthers the number of shares short sellers are willing to sell (try saying that 3 times fast!). As the price goes down, they are making money. So as the price drops they are willing to short more, causes further price drops and less willingness from buyers. This cycle can continue for a while until the stock becomes so undervalued that buying strengthens or that short sellers begin to buy back shares to lock in their gains.
Q&A Series
This post is part of a series of articles in which I answer common questions I’ve been asked. If you have a question leave a comment below or contact me directly.
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