If the price falls, the short seller buys the now-cheaper shares back, returns them to the broker and pockets the difference. But the strategy can be risky. If shares climb — either because other investors make the opposite bet, as in GameStop’s case, or simply because the short seller got it wrong — short sellers lose.
In the past year, as the stock market soared more than 16 percent, hedge funds that were mainly shorting stocks lost nearly 47 percent, according to a Hedge Fund Research index that tracks industry performance.
“Short sellers have been beaten up and left for dead on the side of the road in this bull market,” said James S. Chanos, founder of the short-selling hedge fund Kynikos Associates, who is best known for predicting accounting fraud at Enron before it collapsed in 2001.
Mr. Chanos, who made some money shorting GameStop briefly last week, said short sellers once worried about lawsuits from the companies they targeted. But now they have to worry about attacks on social media and in some cases, personal security.
Ms. Quadir, whose Safkhet Capital manages about $50 million, said it was particularly challenging as a smaller hedge fund. “Try being a fund manager who goes after organized crime, international money laundering, the Russian mafia, all while managing pocket change,” she said.
The GameStop trading mania showed the power of a new force: an army of retail investors fueled by social media, spurred by easy access to free trading apps and bent on teaching hedge funds a lesson. Hedge funds “have left retail holding the bag for YEARS,” posted one user on Reddit, suggesting that GameStop stock was going to the moon with a series of rocket emojis. “I see dead hedge funds,” posted another.
So, short sellers now have to worry about their financial viability. After all, if millions of small investors band together to drive up share prices suddenly, it could raise the cost of shorting stocks to such high levels that short sellers find it untenable to stay in business. That nearly happened to Melvin Capital, which took emergency cash from other investors to right itself.