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1/10/2016

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Risks of Short Selling

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6. Short Selling Analytics

Ross Cameron

7. Short Selling Alternatives
8. Risks of Short Selling
9. Ethics And The Role Of Short Selling
10. Short Selling Guide: Conclusion

Risks of Short Selling
By
Elvis
Picardo,
CFA
Unlike long transactions (i.e., buying shares or other instruments), short selling involves

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significant costs, in addition to the usual trading commissions that have to be paid on stock

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transactions. These include:

Margin interest – Margin interest can be a significant expense when trading stocks on
margin. Since short sales can only be undertaken in margin accounts, the interest
payable on short trades can add up over time, especially if short positions are kept open
over an extended period.
Stock borrowing costs – Shares that are difficult to borrow – because of high short
interest, limited float, or any other reason – have “hard-to-borrow
“hard-to-borrow”” fees that can be
quite substantial. This fee is based on an annualized rate that can range from a small
fraction of a percent to more than 100% of the value of the short trade, and is pro-rated
for the number of days that the short trade is open. As the hard-to-borrow rate can
fluctuate substantially from day to day and even on an intra-day basis, the exact dollar
amount of the fee may not be known in advance. The fee is usually assessed by the
broker-dealer to the client’s account either at month-end or upon closing of the short
trade, and if it is quite large, can make a big dent in the profitability of a short trade or
exacerbate losses on it.
Dividends and other payments – The short seller is responsible for making dividend
payments on the shorted stock to the entity from whom the stock has been borrowed.
The short seller is also on the hook for making payments on account of other events
associated with the shorted stock, such as share splits, spin-offs and bonus share issues,
all of which are unpredictable events.

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Apart from these costs, risks associated with short selling include the following:

Risk of short squeezes and “buy-ins” – A stock with very high short interest may
occasionally surge in price—typically when a positive development in the stock or broad
market triggers massive short-covering—creating what is known as a “short
“short squeeze.”
squeeze.”
Heavily shorted stocks are also vulnerable to “buy-ins,” which occurs when a brokerhttp://www.investopedia.com/university/shortselling/shortselling3.asp

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as sellers rush to buy the stock to cover their positions. inflation should drive its stock price up somewhat. a stock can't go below 0. it has to be opportunistic and well timed. This rush creates a high demand for the stock quickly driving up the price even further. you open a margin account.500. If your account slips below this. even if a company barely improves over the years.) Short squeezes can wring the profit out of your investment. keeping a short position open for a long period can become very risky. This is why it's not a good idea to short a stock with high short interest. A short sale loses when the stock price rises and a stock is (theoretically.1 and The Stock Market: A Look Back. but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. news in the market will trigger a short squeeze.com/university/shortselling/shortselling3. which allows you to borrow money from the brokerage firm using your investment as collateral. short selling is a contrarian strategy. This phenomenon is known as a short squeeze. it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. most stocks appreciate in price. Such actions can cause a sudden spike in stock prices. in general. Usually. When stock prices go up short seller losses get higher.1/10/2016 Risks of Short Selling | Investopedia dealer closes out short positions in a difficult-to-borrow stock because its lenders are demanding it back. so your upside is limited. Contrary to long-term market trend – As the long-term trend of the market is upward. (To learn more. if you short 100 shares at $65 each hoping to make a profit but the shares increase to $90 apiece. but the best you can earn is a 100% gain if a company goes out of business and the stock loses its entire value. call. but the maximum loss is theoretically infinite. On the other hand. see Short Squeeze The Last Drop Of Profit From Market Moves. (To learn more. and you'll be forced to put in more cash or liquidate your position.) Even if you're right. This is known as margin trading. trading.asp 2/5 . Over the long run. Just as when you go long on margin. Unlike a buy-and-hold strategy. Short selling is a gamble. When short selling. When you short sell.) Losses can be infinite. value. Trading Center Shorting stocks involves using borrowed money. but you can read more in our Margin Trading tutorial. (We won't cover margin in detail here. The risk of a “buy-in” is a major risk with short selling because of its unpredictability and can lead to unexpected losses for the short seller. Skewed payoff ratio – Short selling has a skewed payoff ratio as the maximum gain – which occurs if the shorted stock was to fall to zero – is limited. Regulatory risks – Regulators may sometimes impose bans on short sales in a specific sector or even in the broad market to avoid panic and unwarranted selling pressure. you'll be subject to a margin call. forcing the short seller to cover short positions at huge losses. What this means is that shorting is betting against the overall direction of the market.investopedia. For example. So. squeeze. if the direction is generally upward. http://www. Bottom line: you can lose more than you initially invest. History has shown that. you end up losing $2. at least) not limited in how high it can go. it could be at the wrong time. read Stocks Are No. stocks have an upward drift. your losses can be infinite. A short squeeze is a great way to lose a lot of money extremely fast. For that matter.

you are vulnerable to interest. Risks of Short Selling 9.. it's something you don't want to stand in front of.1/10/2016 Risks of Short Selling | Investopedia The final and largest complication is being right too soon. Academics and traders alike have tried for years to come up with explanations as to why a stock's market price varies from its intrinsic value. for example. Sure. Take the dotcom bubble bubble. This is contrary to the popular belief that pre-1999 valuations more accurately reflected the Nasdaq.investopedia.com/university/shortselling/shortselling3. Ethics And The Role Of Short Selling 10. All it takes is one big shorting mistake to kill you. They have yet to come up with a model that works all the time. margin calls and being called away. In the meantime. Next: Ethics And The Role Of Short Selling 6. it could conceivably take a while to come back down. it wasn't until three years later. Whether in physics or the stock market. don't fight against the trend of a hot stock. Even though a company is overvalued. Short Selling Guide: Conclusion RELATED TUTORIALS TAXES Capital Gains Tax 101 By Investopedia Staff BONDS & FIXED INCOME Investing For Safety and Income Tutorial By Brian Perry ECONOMICS American Depositary Receipt Basics By Investopedia Staff INVESTING BASICS Stock Basics Tutorial By Investopedia Staff ACTIVE TRADING FUNDAMENTALS Introduction to Stock Trader Types By Ian Harvey http://www. However. you could have made a killing if you shorted at the market top in the beginning of 2000. but many believed that stocks were grossly overvalued even a year earlier. and probably never will. Short Selling Analytics 7. that the Nasdaq returned to 1999 levels. Short Selling Alternatives 8. although two-thirds of the stocks declined. Momentum is a funny thing.asp 3/5 . in 2002. You'd be in the poorhouse now if you had shorted the Nasdaq in 1999! That's when the Nasdaq was up 86%. Just as you wouldn't jump in front of a pack of stampeding bulls. value.

it indicates it replaces most or all of its holdings over a one-year period. Read Full Answer >> Q: Is there a difference between financial spread betting and arbitrage? (AAPL. or commodity in order to close ..... NFLX) A: Financial spread betting is a type of speculation that involves a highly leveraged derivative product.investopedia.. A trade on the short side with an overwhelmingly large number .. especially with the advancements in online trading since the turn of .. Read Full Answer >> Q: What kinds of restrictions does the SEC put on short selling? A: Since the stock market crash in 1929. Purchasing a security. A stock split is a decision .. currency. It is the opposite of going long or buying a stock with the hope that the .. Read Full Answer >> Q: What is a stock split? Why do stocks split? A: All publicly-traded companies have a set number of shares that are outstanding on the stock market.. ... whereas arbitrage . Read Full Answer >> Q: How do I place an order to buy or sell shares? A: It is easy to get started buying and selling stocks.. and the ensuing Great Depression.. A catalyst in equity markets is a revelation or event that propels . RELATED FAQS Q: Is short selling a form of insurance? A: Short selling really isn't a form of insurance. short selling has been the scapegoat in many market .. Read Full Answer >> BROWSE BY TOPIC: Beginning Investor Short Selling http://www.com/university/shortselling/shortselling3.... The absolute level of a fund's investments.1/10/2016 Risks of Short Selling | Investopedia RELATED TERMS Markdown Catalyst Investing Bear Closing Crowded Short Gross Exposure The difference between the highest current bid price among dealers .asp 4/5 . The act of committing money or capital to an endeavor with the ..... Read Full Answer >> Q: What does a high turnover ratio signify for an investment fund? (KNOW) A: If an investment fund has a high turnover ratio.

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