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My understanding is that when you short a stock you borrow it from a broker and the broker in turn usually borrows it from one of their other customers.

Now let's say the stock suddenly rockets in value, to the point that the customer can't cover the short? What happens? Does the broker take the hit?

If the broker is the one who normally takes the hit what if the broker can't cover it either? Does the person whose stock was borrowed take the hit?

Brythan
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Peter Green
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    "If the broker is the one who normally takes the hit what if the broker can't cover it either?"

    If your short losses were big enough to bankrupt your broker, now that would be quite an event.

     – JBGreen Jul 05 '19 at 22:33
  • Such blunder only happens in third world country that doesn't control the short during Asia economic crisis. Now every countries broker set a threshold for shorting. – mootmoot Jul 05 '19 at 22:57
  • Broker borrows shares from in house account. If shares not available in house then he borrows them from another broker with lendable shares. You need to distinguish covering the short from having the margin to cover the short. If stock is trading, it is buyable and the short is coverable. If the trader's account lacks the margin to pay for covering it then the broker closes out existing positions in the account to cover the deficit (long and short). If that is insufficient to cover the cost of the purchase then the broker chases the trader legally for any outlay made by the broker. – Bob Baerker Jul 06 '19 at 00:01
  • See How did this day trader lose so much? for an example of when this situation happened. – Ben Miller Jul 06 '19 at 12:34
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    Reddit says "Hi". – scott.korin Jan 29 '21 at 19:57
  • Haha. So it’s January 2021 now and what y’all called impossible is happening. So I guess the question will be answered soon! – Kellyc Jan 30 '21 at 04:00

4 Answers4

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Buying and shorting on margin requires 50% margin.

If you short 100 shares at $100 the you have:

$10,000 Market Value

$ 5,000 Equity

$15,000 Credit

Margin is Equity/Market Value = 50%

The Minimum Margin Maintenance Requirement for NASDAQ and NYSE stocks is 25% though brokers can require more (leveraged ETFs require more margin). The MMMR is Credit/1.25 = $12,000. At $120 per share, you'll have 25% margin ($3,000/$12,000):

$12,000 Market Value

$ 3,000 Equity

$15,000 Credit

In the old days, if you modestly breached the MMMR, brokers would give you a warning and up to 3 days to meet the margin call. These days, the computers at online brokers monitor the margin level closely and they tend to close violations out, often with poor fills. Some might give you the opportunity to transfer other in house assets into your margin account to meet the margin call.

If your position sky rockets and blows through the remaining 25% of margin with no opportunity to close (for example, a buy out offer), your position will be closed ASAP by the broker. The lender of the shares does not take the hit. The broker does and will chase you legally.

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Bob Baerker
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    "your position will be closed ASAP by the broker" -- how does the broker do that if there are no willing sellers of the stock -- or if the short-seller does not have enough assets to pay for the stock that is for sale? – hmakholm left over Monica Jul 06 '19 at 12:06
  • Have you ever experienced a situation where there were no sellers of a stock or is this some hypothetical that you have dreamed up? If the former, source it. For more detailed explanations of margin calls due to Minimum Margin Maintenance Requirement violations, google "Liquidation Margin" and "Forced Liquidation". – Bob Baerker Jul 06 '19 at 14:49
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    I haven't experienced such a situation, no -- but that doesn't change that such a situation is what the question is asking about. – hmakholm left over Monica Jul 06 '19 at 14:56
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    @HenningMakholm No it isn't. The relevant line from the question: "the stock suddenly rockets in value, to the point that the customer can't cover the short?" So the problem isn't that there is no seller. The problem is that the shorter lacks the funds to buy from anyone willing to sell. Which is what the question answers. In regards to your question about what happens if the shorter lacks assets, see "The broker does and will chase you legally." I.e. the broker covers any difference and attempts to collect from the shorter afterward. – Brythan Jul 07 '19 at 07:18
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    @HenningMakholm - You are conflating the trader lacking the funds to cover versus the short stock being coverable. Brythan clearly delineated the difference. – Bob Baerker Jul 07 '19 at 13:41
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Normally you handle that with a "stop-loss" order that buys the stock (closes out your short) if it rises to a certain price. You're asking what happens if you don't, or can't, and it rises quickly.

They will automatically force you to buy to cover it. If that disadvantages you, they really don't care.

They will use your brokerage account's assets. Starting with cash positions obviously, but they will cheerfully sell any asset without considering the tax impact. Stocks held long obviously, shorts that are in the money, anything positive.

As for negative assets (like other shorts), as they strip assets, you have less assets to cover the broker's risk on those... so they may force their sale also. This can become a cascade.

If cashing you out isn't enough, they'll loan you the money, and you must pay it. But this means the broker really screwed up, got fantastically unlucky, or is very, very confident you have outside assets to cover it.

Then you pay, or a) you won't be doing any trading there, and b) after the mark hits your credit report, you won't be doing any trading anywhere else, either.

What if it's rising slowly? Then the broker may contact you to ask you to put more assets in the account (or voluntarily close out the short). This is called a "margin call".

Harper - Reinstate Monica
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    "They will force you to buy" doesn't explain what happens if there isn't any stock for sale by the time the borrowed stock was supposed to be returned. It also doesn't explain what happens if there is stock for sale but only for such a high price that the short seller doesn't have enough money to pay for it. – hmakholm left over Monica Jul 06 '19 at 12:01
  • @HenningMakholm On your second, I had touched on it, but I have added much detail. On your first question "Stock is no longer available at any price", that is not OP's question. Feel free to ask your own, I'm kinda curious myself... not least how a stock of value would cease to be traded. – Harper - Reinstate Monica Jul 06 '19 at 16:12
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    Added detail acknowledged, +1. I may be misunderstanding the OP, but my immediate reading when he said "suddenly rockets in value" was that he was imagining something at least pretty close to "not available at any price" -- say, if a lot of the circulating stock has just been snatched up (from short sellers!) by someone who's aiming for a controlling interest, who now demands billions to part with any of it, and there's not enough still-circulating stock to cover all of the short interest at once. I.e., something like the great Volkswagen squeeze of 2008 dialed up just one or two notches. – hmakholm left over Monica Jul 06 '19 at 16:24
  • @HenningMakholm Yes, I think what you're describing is an edge condition beyond OP's intent. One seeking controlling interest only needs 51%, and he'll pay no more than he must. The madman buying up every share is economically unable to offer a million a share to every seller; whatever number he is able/willing to offer, bid a penny more and it's yours. If you're imagining a small and rarely traded stock that's too illiquid for that to work, the broker shouldn't have let you short that. – Harper - Reinstate Monica Jul 06 '19 at 16:51
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    The VW short squeeze is an amusing situation, where short sellers needed to buy more shares than had willing sellers in the market, causing a run-up. But there's a counterforce that would prevent it being driven up a notch or two. A hoarder would simply offer the stock for sale at 20x normal price, sell to the shorters, then after the rush is over, use the proceeds to buy 20 shares. It would be foolish not to do that, so every hoarder would, the second one would offer 19x, the next 18x, the first 17x, driving the price to equilibrium. – Harper - Reinstate Monica Jul 06 '19 at 17:11
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    If a stock is publicly traded, there are always shares available to buy. The question is, at what price? There is no such thing as not coverable. – Bob Baerker Jul 07 '19 at 13:46
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You agree to certain terms when you initiate a short position. If, by some sort of magic, the transaction goes off the rails beyond the safeguards imposed by your broker you would simply be in breach of contract and get sued.

Courts exist to sort these situations out.

These fantastical situations where no shares exist to cover or whatever might seem like interesting thought expirments but ultimately if you agree to something, then can't make good on your end of the agreement, you get sued and the courts work it out.

quid
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The one thing missing here is Naked Shorting, and Short Exempt. In a situation where Naked Shorts flood the market of a stock and are all bought up, and those buyers hold long, this can lead to a situation where shorts (hedge funds and market makers) cannot cover the cost to repurchase all of the synthetics along with the needed legitimate shares. Many will say this is impossible, however that is because they trust the process, and yet the process is greatly self-regulated. (Short interest is self-reported as is covering). The other problem is the Naked Shorting can be covered by paying a fine when a firm is caught rather than covering in the traditional sense. I will not bother to list all the links where Naked Shorting led to small fines when at the same time these criminal organizations made millions in profits and in some instances bankrupted the companies of the affected stock.

Flux
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R.Searles
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