Short selling has rules that apply to all parts of this strategy. Rules on borrowing stock and selling restrictions put shorts in a high cost, high risk play, ruled by brokers, exchanges and regulators. Short sellers know and understand all rules that apply in markets they short.
Are there short selling rules?
Short Story Shorting Stocks course, Lesson 10, answers the question, are there short selling rules? At the end of the lesson, links to related content help you learn more.
What you learn:
Knowing that short selling rules and regulations control how every short selling transaction is done, informs investors about the costs and risks of this aggressive trading strategy. The rules intend to prevent market and stock manipulation or disruptions. Knowing short selling rules are in place helps you become a better-informed investor.
Shorts are market scapegoats
Rules, restrictions and costs affect all parts of short selling. From statutes to policies, it seems short sellers get hit with costs and restrictions from all sides. Short sellers play a lonely, unpopular game with no support. The short selling accounts that must be opened are margin accounts separate from any other holdings that accept unlimited risk. No tax or savings shelters apply as short selling is fully exposed to market and short selling risks.
Shorts comply with the rules of the stock lender rules and pay their fees. Selling the borrowed inventory has to be done when prices are level or rising. Restrictions to selling on the downtick has been somewhat relaxed, but short selling still can’t occur on sliding stock prices. That prevents any cascade of short selling from driving down a stock price or market.
Easy to borrow and hard to borrow
One complication of short selling is finding inventory to borrow and sell. Brokers have lists of stocks that are “Easy to Borrow” and others that are “Hard to Borrow”. The easy list includes the large liquid stocks that trade in high volume. All others are basically, “Hard to Borrow”.
Shorting an “Easy to Borrow” stock is relatively straightforward, as the name implies an inventory is readily available to borrow and sell. The rub can come when a prospective short target has not made the “Easy to Borrow” list. Complications and expenses can quickly add up when a short seller wishes to move on a target listed as “Hard to Borrow”.
Rules make market complications!
As lessons in this course point out, selling short can get complicated and expensive from end to end. The final complications are the rules short selling must follow. Financial service providers, brokers, dealers, stock exchanges and regulators all impose rules on short selling.
Rules are in place to restrict or inhibit extreme, disruptive or manipulative stock price action. For the good of the market and economy, rules control and prevent any artificial price pressure on capital markets or an individual stock. The intention is to have fair markets but still allow for true short selling interests to function.
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.
Margin required
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 broker used by the short seller, may impose still higher margin requirements. Or without notice, change the margin requirements as they see fit.
Remember, the short seller carries an open liability. Borrowed stock got sold short. For security, brokers require that short sellers keep a level of cash available in their account. It varies by firm and circumstances, but an amount of 25% of the value of the short position, is a typical opening position. It becomes a case of the short seller can see cash sitting in their account, but can’t touch it or use it for other purposes! It becomes one more expense a short seller must manage.
A little extra
It gets more onerous yet. As short plays unfold, brokers often increase the cash requirement by a significant amount. That increase in the required cash or equivalent holdings can be 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 is 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.
Margin calls
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 broker needs to keep well ahead of the market. Should the trade go poorly, without prior notice, the short selling client can get called to immediately produce more cash. Any failure to quickly respond, act and produce the required cash triggers market orders. Should market orders be released the short position can get covered. However that usually devastates the short 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 broker does not want any client that sells short to have their accounts overly concentrated in short positions. Any account causing such concerns immediately meets a call for more cash for security.
As before, any failure to immediately respond, means the broker will close the position. That could be a very painful financial experience!
Regulator rules
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 also have a regulatory function.
The purpose of White Top Investor lessons is introducing anyone that is interested, to the basics of investing in stock markets. As an introductory mission we have not needed 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 is to curb or limit any downward price pressure that could accelerate falling prices.
Ensuring market integrity and preventing manipulation are major focuses 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.
Buy-in risk
The broker may call for the borrowed shares to be returned. That forces the short seller to buy the shares in the market and return them.
That bit of financial nastiness can happen if the broker 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 seller has to scramble to buy them in the market to produce the shares. A buy-in could also be required if the broker 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.
Brokers always factor in short sales
Brokers 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 loss 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 and twists that can prove costly. This lesson gives you the flavor of these possibilities. Short selling rules and restrictions mean brokers, 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.
Experience urges short selling caution
Wrapping up the Short Story Shorting Stocks course with this lesson, Short selling has rules, this seasoned elder urges you to be careful out there and consider these bigger picture short selling cautions:
- Should you decide to try short selling, make sure your technical and analytical skills are current and sharp. Know and have experience applying both fundamental and technical analysis. Have your trading knowledge and skills well established and backed by experience.
- Trees don’t grow to the sky but sometimes they do die! That means stocks don’t, can’t and never will grow up forever but they can fail, and companies do go bankrupt.
- Predicting tops and bottoms in price patterns for a stock or market is a high-risk way to set up trading for profit.
- Successful short sellers exercise discipline and have superior money management skills. If that is not you, don’t start learning these essential skills by short selling. Rather, develop and have those habits well established before considering selling short.
- Be sure you understand risk/reward ratios and how to make them favorable. Have a loss prevention plan in place.
Final facts why you should not short sell
- Short selling well is difficult with a capped upside and large downsides.
- When short selling goes wrong, a huge loss can wipe out many gains.
- Shorts must be right about the stock, the market and most important have the timing right.
- Setting stops in the markets for loss protection is not an absolute – know that stops can fail losses can get ugly.
- Many skilled short players can make an attractive short play a very crowded and competitive play. Your competitors are experienced pros.
- Short squeezes are real and despite the rules, can be orchestrated.
- Fees due to brokers can be a significant continuing cost.
- Long term markets trend up against shorts timing contrarian moves.
- Shorts are short term active plays that make mistakes more likely.
- Shorts are short term high-stress plays requiring constant attention.
- Researching, monitoring and playing shorts takes huge chunks of time.
- Mistakes are costly and can grow fast if they run against the short.
- Going public, announcing or using social media to broadcast a short position can get plenty of attention! Your knowledge, intelligence and heritage will be questioned or most likely insulted. Short sellers have thick skin! Short selling can attract flaming, spam and trolls as well as lawsuits and complaints to regulators. Mostly meaningless noise gets generated but it will certainly add interest to your day!
Making money selling short is certainly possible. I have done it. I have had success and fails shorting so certainly know it can, and does, work. However, it is a very challenging and demanding way to make money.
Shorting is a perfectly legitimate strategy that some people view as evil, bad for markets, bad for investing and against capitalism. That is nonsense. Most successful shorts simply keep quiet, carry on and make money.
My warnings and caution expressed above are not against shorting or people who use the strategy. My point here is that short selling is a demanding strategy that you should know about but it is not for beginners.
Consider the option of options
If you contemplate using a short selling strategy, first consider using options as an alternate. For someone new to investing, considering the option of options will open the door to the vast world of options, futures and derivatives. That is no place for someone just beginning but is worthy of consideration as you develop you investing knowledge and skill.
Options offers many financial possibilities. Included are using options as ways to play “short” on a stock or company you think is overvalued or going to fall in price. Just be sure to learn before you begin to do.
Question Answered!
Yes, there are short selling rules; knowing that short selling rules and regulations control how every short selling transaction is done, informs investors about the costs and risks of this aggressive trading strategy. The rules intend to prevent market and stock manipulation or disruptions. Knowing short selling rules are in place helps you become a better-informed investor.
Lesson takeaways,
Short selling has rules:
Short selling has rules that apply to all parts of this strategy. Rules on borrowing stock and selling restrictions put shorts in a high cost, high risk play, ruled by brokers, exchanges and regulators. Short sellers know and understand all rules that apply in markets they short.
- Rules complicate, restrict and add costs to short selling.
- Short sellers effectively operate on margin with all associated risks.
- Without notice broker cash calls add costs and complicate shorting.
- Brokers closely monitor shorts including concerns of an overly concentrated position or lack of diversification.
- Short sellers have positions closed when unable to answer cash calls.
- Regulators impose short rules that can vary by jurisdiction.
- Shorts have buy-in risks when the stock owner wants to sell the stock.
- Short selling requires knowledge, skill and experience to do well.
- Short selling is a complex strategy not for use by beginners.
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Short Story Shorting Stocks lessons:
Short selling stock explained Lesson 1
Short selling improves markets Lesson 2
Short selling improves companies Lesson 3
9 Short seller facts investors need Lesson 4
Making money selling short Lesson 5
Shorting stocks has risks Lesson 6
Who’s selling your stock? Lesson 7
Short sellers need skills Lesson 8
Short seller cost control Lesson 9
Short selling has rules Lesson 10
Next course:
High Frequency Trading Explained
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