Risk of short selling

(1) Risk and return are not equal

The imbalance between risk and return is the inherent risk of short selling. In theory, when an investor goes long on a stock, the maximum loss is when the stock price drops to 0, that is, the loss ratio is 100%; but when an investor goes short on a stock, there is no limit to the subsequent rise in the stock price relative to the price of the short, so the potential loss is unlimited, which may be 200%, 300% or even higher.

(2) Time cost

Short selling must consider the time factor. On the one hand, because short selling operations generate interest every day, the accumulated cost increases over time; on the other hand, the greatest uncertainty of short selling also comes from time. If investors hold short positions for a long time, they may face the risk of rising stock prices.

(3) Interest rate risk

It should be noted that after placing a short order, the short interest rate still changes. The interest paid by investors is calculated based on the actual daily interest rate from the day of the short order, and is calculated at 23:00 in the market (23:00 in US time for US stocks and 23:00 in Hong Kong time for Hong Kong stocks). The financing and securities lending interest will be deducted from the cash balance of your stock account. No one can determine the short interest rate in advance. If the degree of short-selling congestion in individual stocks increases significantly during the short-selling period, causing a significant increase in interest rates, investors need to bear the increased short-selling cost, making the short-selling interest greater than the short-selling income and resulting in losses.

(4) Recall and forced liquidation

When shorting, the relationship between the short investor and the lender is unequal. The stock lender/lender reserves the right to request a recall of the stock at any time. If a recall occurs, the broker will attempt to replace the previously borrowed stock with the stock borrowed from another lender. If the stock cannot be borrowed, a formal recall will be initiated. Recalls usually use volume-weighted average price (VWAP) orders to close the customer’s short position. In addition, if the stock price continues to rise after borrowing, the margin requirement for the stock will also continue to increase. Once the margin is insufficient, a forced liquidation will be triggered. If a stock with a high proportion of bears rises sharply, it is likely to cause many short investors to rush to position squaring during the same period, leading to further price increases.

(5) Company actions

Certain company actions (such as mergers, acquisitions, dividends, etc.) may cause an increase in short selling fees. For example, when a company announces dividends, it usually leads to a decrease in the supply of stocks in the market, which may lead to an increase in short selling rates.

(6) Delisting and delisting

When a stock is delisted or delisted, investors may not be able to fill their short positions because the stock cannot be traded. They need to wait until the stock is delisted or the stock resumes trading before terminating. This process may last for several days, months, or even longer, especially when the company goes bankrupt and liquidates. During this period, investors have to continuously pay margin trading fees based on the delisting price of the stock or the Closing Price of the most recent trading day, which may be very high.