The practice of shorting stocks occurs when shares are borrowed from a broker, with an agreement they will be returned at a later time. The stock is then sold immediately. If the stock price falls, the short seller can repurchase the shares and return them to the lender. Short selling can be an effective strategy for many traders. Effective short sellers understand the risks associated with shorting stocks. If you are looking into shorting shares, you must be aware of these risks that can hurt your portfolio.
Since the investor does not own the stock / security, it is typically borrowed from a broker. The investor must pay a fee to the lender for the borrowed stock. Shares that are difficult to borrow carry a hard-to-borrow fee. This can range from less than 1% to 100% of the trade value. This can become costly and the costs can add up quick!
When a heavily shorted stock rises sharply, shorts rush to cover their positions. This sends the price higher, rapidly. Being caught on the wrong side of a short squeeze can be catastrophic and losses can multiply quickly.
Buy in Losses
A broker has the power and can close out a short position for difficult-to-borrow stocks. This can often lead to unexpected losses for the short trader. It’s not fun to be on the losing side of a buy in loss.
Short sellers are responsible and must make dividend payments to the lender on the shared stock. Holding short shares through dividend dates should be avoided if possible, unless you’re ok with paying out dividends.
When short positions are held for extended periods of time, the interest can add up and become very costly. Just like anything, a little becomes a lot, and over time margin interest can really become an issue.
Short sellers also pay lenders on events such as splits, spin-offs and bonus shares. Most of this is pretty much unpredictable and can happen at any time. Just another risk associated when holding short positions.
It’s important to understand these six risks as a short seller. The more you learn, the more you earn! If you have any questions or comments about short selling risks, feel free to use the contact form below to get in touch with us.