Short Selling Limitations and Risks

Table of Contents
Chapter 1: Introduction to Short Selling Stocks
Chapter 2: Short Selling Terminology
Chapter 3: Short Selling Limitations and Risks
Chapter 4: Who Should Get Involved in Short Selling
Chapter 5: Factors to Consider before Short Selling

Navigate This Page
Chapter 3: Limitations and Risks
Limitations of Short Selling
Round Lot Trading
Types of Securities
SHO Regulation against Naked Shorting
SHO Uptick Rule
Risks of Short Selling

Chapter 3: Limitations and Risks

Short selling is not an investment option for the faint hearted. The risks are very high and there is a possibility that the investor could lose heavily with a short sale.

There is another consideration, a more ethical one. A short seller gambles that the price of a stock will decline. In effect, he hopes that the business or company will fail in the near future. The stock market witnesses transactions by several short sellers everyday and it is in the best interests of this group of investors for the markets to fall. Unethical short sellers aren’t sometimes beyond spreading negative rumors about a company whose shares they have shorted on to push the price down.

The SEC has strict regulations in place to curb this kind of deliberate campaign against companies and also to make sure that an existing bearish trend isn’t further worsened by short selling. If these are allowed to happen, investors cannot flourish in a balanced market and stock prices will not really reflect the true value of a company.

Such artificially lower prices or enormous volumes of short selling can sometimes hasten a market crash. The 1987 market crash was attributed by experts to massive short selling. The various limitations on short selling help avert such problems.

Limitations of Short Selling

  • Round Lot Trading: Short sellers can only trade in round lots of shares which means that only blocks of 100 shares can be sold short in the market.

  • Types of Securities: Securities that trade at a low price, typically below $5 or are not listed on major stock exchanges cannot be short sold. Such stocks are often classified as penny stocks. They are considered highly speculative and investing in them is very risky. The SEC prevents short selling on these to contain the risk that is in these investments.
  • SHO Regulation against Naked Shorting: The SEC brought in this regulation to ensure that short sellers could actually fulfill the delivery requirement for the stocks they have shorted. A short seller is required under this regulation to provide enough evidence that he can get possession of the securities he has to repay. This prevents speculators like day traders from making massive short sale transactions with zero initial investment and without having the necessary funds or access to buy back securities if it becomes necessary.
  • SHO Uptick Rule: The uptick or zero plus tick rule ensures that excessive short sales do not lower a stock’s price unnaturally. Under this rule, every short sale needs to be done at a price which is higher than the previous one. The uptick rule has been suspended at times by the SEC. In February 2010, amendments were brought to the SHO rules. The general ban on selling at lower price has been modified in favor of a stock specific one. A trigger price will be identified for each of these specified stocks and the uptick rule will come into play when the price falls below the trigger price.

Risks of Short Selling

Short selling is a risky affair, no matter how many regulations and limitations are imposed by the SEC to safeguard the markets. Here is a brief look at some of the risks involved.

There is no ceiling on how much a short seller can lose in a trade. The share price may keep going up and the short seller will have to pay whatever the prevailing stock price is to buy back the shares. However, his gains have a ceiling level because the stock price cannot fall below zero.

A short seller has to undertake to pay the earnings on the borrowed securities as long as he chooses to keep his short position open. If the company declares huge dividends or issues bonus shares, the short seller will have to pay that amount to the lender. Any such occurrence can skew the entire short investment and make it unprofitable.

The broker can use the funds in the short seller’s margin account to buy back his loaned shares or issue a ‘call away’ to get the short seller to return the borrowed securities. If the broker makes this call when the stock price is much higher than the price at the time of the short sale, then the investor can end up making huge losses.

Next Chapter: Who Should Get Involved in Short Selling

  • doubleducks

    Is it illegal to accumulate a very large long position of a stock over a long period; say a million shares over 3 months. Then take a huge short position, followed immediately by selling your million shares in one day, forcing the price of the stock much lower. Then reaping huge gains by your short position.

    If this is legal, is this what hedge funds do regularly?