How Does Short Selling Work in the Stock Market?

Author: Yan Chan, capital manager at Axone Capital

2026-08-09 · 7 min read

Short selling means betting that a stock's price will fall, and potentially profiting during a crash. But it's also one of the riskiest strategies in finance. Here's how it works, why it's dangerous, and what history teaches us about the famous short squeezes.

The Analysis: Selling What You Don't Yet Own

Short selling is one of the most misunderstood techniques in finance. It consists of betting on the decline of a security rather than its rise.

Here is the exact mechanism, step by step:

  • Borrowing: you borrow 100 shares of company X from your broker, who holds them on behalf of other investors. You pay daily borrowing fees.
  • Selling: you immediately sell these 100 shares on the market at the current price, say €50/share. You receive €5,000.
  • Waiting: you wait for the price to fall.
  • Buying back: if the share drops to €30, you buy back 100 shares for €3,000.
  • Returning: you give the borrowed shares back to your broker.
  • Profit: you pocket €2,000 (5,000 - 3,000), minus borrowing fees.

Key parameters of short selling

  • Borrowing fees: 0.5% to 10%/year depending on the scarcity of shares available to borrow
  • Margin call: if the price rises, the broker can demand an additional deposit
  • Potentially unlimited loss: a share can fall to 0 (max gain = 100%), but it can theoretically rise infinitely
  • Short horizon: short selling is rarely a long-term position; costs accumulate

Short selling plays an important role in market efficiency: it allows investors who detect overvaluation to correct it more quickly. Short sellers identified Enron, Wirecard and several accounting frauds before regulators did.

But it is also one of the few strategies where your losses are mathematically unlimited.

The Anecdote: Melvin Capital vs Reddit (January 2021)

In January 2021, a U.S. hedge fund called Melvin Capital had a massive short position on GameStop, a declining video game retailer. The reasoning was simple: e-commerce was destroying its business model, revenues were falling, bankruptcy seemed likely.

But members of the Reddit forum WallStreetBets decided to fight back.

Within days, millions of retail investors massively bought GameStop stock. The price went from $17 to $483 in less than three weeks.

Melvin Capital, caught in a short squeeze (see concept below), lost more than $6 billion in January 2021, over 50% of its assets under management. The firm had to be bailed out by other funds and ultimately closed in 2022.

What this story illustrates: even a fundamentally correct thesis (GameStop was indeed overvalued at $483) doesn't protect you if the market moves against you longer than you can hold your positions.

"Markets can remain irrational longer than you can remain solvent.", attributed to Keynes.

The Historical Fact: Volkswagen, the World's Largest Company for 24 Hours (2008)

In October 2008, at the height of the global financial crisis, Volkswagen briefly became the most valuable company on the planet, ahead of ExxonMobil. Its stock multiplied tenfold in two days.

The cause? A spectacular short squeeze.

Porsche, which coveted Volkswagen, had quietly accumulated call options on the stock. By publicly revealing that it held (directly or via options) nearly 74% of VW's capital, Porsche triggered a panic among short sellers.

Investors who had shorted VW, thinking the crisis would send the stock lower, scrambled to buy back their positions. But almost all the available shares were in the hands of Porsche and the State of Lower Saxony (12%). There was almost nothing left to buy on the open market.

The rush to buy back sent the price exploding: from €210 to €1,005 in two sessions.

Losses for short sellers were estimated at €30 billion. Some large funds had to sell other positions to cover their margin calls, feeding the broader market decline in the midst of the subprime crisis.

The Concept: The Short Squeeze

The short squeeze is the secret weapon that makes short selling particularly dangerous. It occurs when a heavily shorted stock rises sharply, forcing short sellers to buy back their positions urgently, which pushes the price even higher, forcing more buybacks... a self-reinforcing spiral.

Three conditions create a short squeeze:

  • High short interest: many investors are betting against the stock
  • A bullish trigger: good news, an unexpected announcement, or simply a coordinated wave of buyers
  • Low liquidity: few shares available for purchase, which amplifies every move

For retail investors, the moral is clear: short squeezes are often buying opportunities for those who anticipate them, and disasters for those who are caught in them.

The Axone Lesson

Short selling is a legitimate and useful tool for markets. But for retail investors, the risk profile is unfavourably asymmetric: gains are limited to 100% (if the stock falls to zero), while losses are theoretically unlimited.

Before shorting a position, ask yourself three questions:

  • What is my time horizon? The longer you hold, the more fees accumulate.
  • What is my tolerance for a margin call? The market can "explode" against you before you're proven right.
  • What is the existing short interest? A heavily shorted stock carries latent squeeze risk.

At Axone Capital, we prefer to identify overvaluations as a signal to exit a long position, rather than actively betting on a decline. The Macro · Technical · Mindset method puts risk management first. And the unlimited downside of short selling is precisely what a disciplined investor avoids.

Published on Axone Capital, capital management, macro analysis and trading by Yan Chan.