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Government regulates stock short-sale practices

With all of the news lately regarding GameStop — and me not being a stock trader — I would like to know how hedge funds selling short can even be legal. It just doesn’t seem right to bet on a business to fail. Will you please explain this to me?

— Chris, Central Point

The short answer probably boils down to you can’t legislate morality, and everything legal is rarely the “right” thing to do.

However, that doesn’t mean anything goes when it comes to short-selling, at least as far as the U.S. Securities and Exchange Commission is concerned.

Short-selling is when an investor sells stocks they borrowed and promises to return them later because they believe the price is trending down, according to the SEC website. Short sales have been regulated since 1938.

If the stock’s price falls as planned, the investor — be it an individual or a hedge fund that uses pooled resources — buys the stock at a lower price, returns the shares he, she or they borrowed, and pockets the difference.

Investing carries risks, and that’s far from a certain outcome. GameStop rose to prominence in part because it was at one point one of the most-shorted stocks before it soared to unprecedented heights.

To paint a very complicated situation in broad strokes, many investors believed the practice of buying video game discs at a physical store was a business model going the way of horse-and-buggy whips and Blockbuster Video, but then people on a certain Reddit forum started posting rocket emojis and “We like the stock” among other jargony posts not suitable for a family audience.

According to the SEC, the “vast majority of short sales are legal,” but “abusive short-sale practices are illegal.”

Abusive short-sale practices are considered “market manipulation,” according to the SEC. Two examples include “engaging in a series of transactions to create actual or apparent active trading in a security” and “depressing the price of a security to induce other investors to purchase or sell the security.”

Send questions to “Since You Asked,” Mail Tribune Newsroom, P.O. Box 1108, Medford, OR 97501 or by email to youasked@rosebudmedia.com. We’re sorry, but the volume of questions received prevents us from answering all of them.