The Dangers of Short Selling Stocks & Bonds

Short selling can create unlimited risk.

Jupiterimages/Goodshoot/Getty Images

"Short selling" seeks to profit from downward price movements. When you short sell shares or bonds, you first borrow them for a fee from a lending broker. You then sell the borrowed securities, and the sale proceeds are deposited in your brokerage account. Sufficient proceeds must remain on deposit to meet collateral requirements until the short sale is terminated. You close a short sale by buying shares of the same stock to replace the borrowed ones -- hopefully at a lower price -- and returning them to the lender. However, short selling can be dangerous.

Short Squeeze

The first danger is that stock or bond prices will rise instead of falling. Because you must buy the securities to replace those you borrowed, rising prices create mounting losses until the short is terminated. A "short squeeze" happens when prices move up substantially, causing panic among short sellers, who then go into the market to buy shares back. The resulting demand raises prices even more. This vicious cycle strikes fear into the heart of any short seller. Because there is no cap on the upward price movement of a stock or bond, a short squeeze can represent unlimited risk to the short seller.

Margin Call

The Federal Reserve Board’s Regulation T requires short sellers to deposit collateral, called margin, with the broker in the amount of 150 percent of the initial value of the shorted securities. For instance, if you short $1 million in Treasury bonds, the initial margin requirement is $1.5 million. You must thereafter maintain your margin level at 100 percent. If T-bond prices rise and your short position is now worth $1.2 million, you will quickly receive a margin call from your broker to put up extra margin, in this case an additional $200,000. If you don't, your broker will liquidate your position, locking in your loss.

Hard To Borrow

In certain hedge trading strategies, traders take a long position in a security, such as XYZ common stock, and they short a derivative security, for instance XYZ convertible bonds. The bonds can be converted into the common stock, which helps raise their price when the stock is strong. If stock prices fall, so should the value of the shorted bonds, thus hedging the loss on the long stock position. However, such positions need to be dynamically adjusted for price changes, perhaps requiring a trader to short additional bonds. The danger is that the bonds may become hard to borrow after the hedge has been established. This can happen the demand for the bonds suddenly outstrips supply. The whole strategy is put at risk because the trader can no longer hedge properly, and he might have to unwind his positions at a loss.

Demand for Return

Short sellers hope to keep a short position alive long enough to profit from a sizable downturn in the security’s price. However, a lending broker can demand the immediate return of borrowed securities. This can happen if the securities become hard to borrow. The broker can charge more to lend out hard-to-borrow securities, so it's in his financial interest to terminate a relatively low-paying arrangement and replace it with a more lucrative one. If the trader cannot find another lender, he will have to unwind his position, again at a possible loss. If the trader doesn’t return recalled securities within a specified period, usually three days, the broker will liquidate the short sale and reclaim the securities.