White Top View series on Short Selling, Part 8
Today in Part 8 of the White Top View series Short Story on Short Selling , we lightly touch the rules of selling short. Naturally, short selling has rules that all must follow. Short sellers have to deal with all the factors we covered in earlier parts of this series and some specific rules that apply only to selling short. Financial service providers, the brokers or dealers, stock exchanges and regulators all impose rules on short selling.
The primary reason for putting rules in place is to restrict or inhibit extreme, disruptive or manipulative stock price action. All involved want to prevent anyone from imposing any artificial pressure price on the capital markets.
Our market rules discussion continues the White Top View series Short Story on Short Selling . Read the earlier posts in the series by clicking on the links at the bottom of this post.
Short selling rules
Short selling has rules which control how, which stock, when and circumstances that allow short selling. No such rules apply when buying long. Maintaining market integrity and preventing price manipulation drives these rule creation efforts.
Without any restrictions, short sellers could hurt companies, certain investors or the markets themselves. Small companies or those with limited share volumes or relatively few shareholders could have prices manipulated by aggressive short selling action.
Additionally under certain market conditions short selling could accelerate a market price correction. That could create more volatility and undermine confidence in markets. Such selling action could be used to manipulate prices for specific companies, industries, sectors or entire markets.
Short sellers need ample assets to play. That means the account of the short seller must have 100% of the market value of the security that they intend to sell short. In effect, the account must keep all the cash proceeds of the short sale in cash.
In addition, a short seller must make cash deposits equal to the total value of any market price increase. Should the market price run up, and not down as the short seller wants, this need can rapidly escalate costs.
On top of that, the specific dealer or broker used by the short seller, may impose still higher margin requirements. Or without notice, change the margin requirements as they see fit.
Remember as well, the short seller carries a liability. Borrowed stock got sold short. Dealers need short sellers to keep the cash available in the account. You can see the cash sitting in your account but you can’t touch it!
A little extra
It gets more onerous yet. Dealers usually increase the cash requirement by a significant amount. Often that increases the cash needs by 50% of the value of the short. That cash, or other securities in that amount that qualify for margin or loan security, are typical!
That means to short, 150% of the value of the short sale has to be in the account. The reasoning of brokerage houses or dealers being that extra security is their protection, should the trade go against the short seller.
There are also other or so-called, maintenance requirements. In other words as market prices or conditions change, the guidelines must continually be met. Should prices or markets go against the short seller, such adverse price action can dramatically increase cash requirements.
Such requirements could mean a margin call for cash. Such calls usually get triggered when market action goes against the short. It could also relate to the broker’s level of concern about the market, the specific trade or the individual client.
The dealer needs to keep well ahead of the market. Should the trade go poorly, without prior notice the client gets called to immediately produce more cash. Any failure to quickly respond, act and produce the required cash triggers market orders. That buys back the short position and covers the debt. But usually devastates the trade.
Such orders are a disaster for the short seller as the buying pressure can dramatically drive the stock price higher. That is a classic short squeeze. It usually produces high volumes of noise and pain. Not nice to see or hear!
Diversification or position concentration
For their own financial security the dealer does not want any client account overly concentrated in a short position. Any account causing such concerns immediately meets a call for more cash for security.
As before, any failure to immediately respond, means the dealer will close the position. That could be a very painful financial experience!
Security and Exchange Commission (SEC) in the USA, or in Canada, the various Provincial Security Regulators, impose rules to prevent market manipulation. The various exchanges each also have a regulatory function.
The purpose of the White Top View blog is introducing new investors to markets. At an introductory level we do not need to get further into the specific short selling rules.
Basically the regulators restrict short selling when doing so could exacerbate or increase falling price pressure in a downturn. The intention being to curb or limit any downward price pressure that could accelerate falling prices.
Ensuring market integrity and preventing manipulation are a major focus for regulators. These rules change from time to time. Short sellers must know and stay current with the rules that affect any short trade that they make.
The dealer may call for the borrowed shares to be returned. That forces the short selling client to buy the shares in the market and return them.
That bit of financial nastiness can happen if the dealer wants to close the liability, the real owner of the shares demands them or most likely, the market strongly moves against the short position.
The real owner of the shares can force a buy-in by simply entering an order to sell their shares and take profits. A buy-in requires the short seller to immediately pay back the borrowed shares. The short has to scramble to buy them in the market to produce the shares. A buy-in could also be required if the dealer has concerns about the business prospects of the company being shorted.
The short seller’s expectation, that the company will weaken or even fail, and that share values will significantly fall, could come true. Should there be any announcement of negative material change in the company, the shares will immediately face a cease-trade order. That stops all trades. Unfortunately, should the market stop trading the shares, buying back to cover the liability becomes impossible. The short could be right and still lose.
Dealers want to avoid the financial and legal complexity of such an eventuality. Should they think such a situation possible, they will do their best to get in front of it. They will simply force an exit to close the position.
Should there be any bankruptcy or takeover concern, such a badly timed exit can force a losses on the short seller. Even when they are right about the failing company! Ironically losses can occur even when the short seller got the big picture right.
Imagine being right about every aspect of a short play and still losing money! An untimely forced exit can make that happen. That could be both incredibly frustrating and very expensive!
Short selling has rules have twists that can prove costly. This post gives you the flavor of these possibilities. Short selling rules and restrictions mean dealers, stock exchanges and regulators all have a say in what and how a short seller operates. At times being right may not mean being profitable.
The next part of the White Top View series Short Story on Short Selling will continue with some positives and market benefits of short selling.
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Read all parts of the White Top View series, the Short Story on Short Selling, by clicking on the links below:
Part 8, Short selling has rules
Part 10, Four more positives of short selling
Part 12, Shorting stocks is hard