Risk of Short Sale Stocks
Forced Margin Call
- Short sale stocks is a process involving the use of margin accounts, as shorting, being a form of borrowing from a broker, can only be done in a margin account. The term margin means an additional margin of safety that guarantees the return of the borrowed shares to the broker against adverse stock price movement. When the stock's price rises, the short seller has to spend more money to buy back the same amount of shares. Brokers mostly require that the amount of cash available in the account is equal to the stock's market value plus an additional 30 percent. As the price of the stock keeps rising, the broker issues the so-called margin call to demand additional funds be deposited into the account. If the account holder fails to meet the margin call, the borrowed shares must be bought back immediately resulting in a potentially big loss.
Untimely Share Buyback
- Short sale stocks and keeping the short position open afterward depend on the availability of the shares of stocks for borrowing. Borrowing shares is arranged by a brokerage firm, either internally from its own inventory or other clients' accounts, or outside from another brokerage firm. If the client who owns the stock borrowed by the short seller is selling the stock himself, the shares are no longer available for borrowing, and the broker has the right to recall the shares without giving prior notice. If the recall comes in when the market price is higher than the short selling price, the short seller incurs a loss buying back the shares.
Potential Stock Split
- Before borrowed shares are returned back, if the company of the stock announces a stock split that gives shareholders an additional share for each share they own, the short seller is obligated to buy back the amount of shares that have now been doubled. However, the stock price following the split would be only half of what it was before, so the short seller's investment value may not be affected by the stock split. But, over time, most stock splits lead to gradual price increases, a risk of potential losses for the short seller when buying shares back.
Dividend Payment Event
- When a stock is borrowed from the original owner, the registered owner of the stock as shown on the holder of record changes because the original owner is no longer the owner of the shares as recognized by the company of the stock. In the event the company makes dividend payments, the company distributes the dividend to the current stock owner to whom the short seller has sold the shares. The broker still credits dividend to the original owner's account, but it is the short seller's responsibility to provide the payment. Depending on the dividend policy of the company of the borrowed stock, there are added uncertainties to the short seller before shares can be returned.
Overall Risk Assessment
- Short sale stocks expand investment opportunities generating profits in down markets. While the maximum gain from short selling is the total short sale proceeds if the stock drops to zero, potential losses are uncertain if a stock continues to rise. To control such potentially unlimited losses, short sellers may use stop-loss orders when entering short sale positions. A stop-loss order allows the short seller to immediately buy back the stock if its price rises to a preset level so that the loss is limited to within an accepted price range.