#6 Margin Calls
And if a stock you have shorted moves the wrong way (up), you are going to need cash to meet margin calls — perhaps daily. Your broker will ask you to put more funds in your margin account, typically enough to cover the purchase of the stock on the open market at the current price.
If you don’t make the payment asked for by your broker and you have other securities held long in that margin account, your broker will sell those securities to meet the margin call.
#7 Early Sale
If the original owner decides to sell the stock, you must replace it — either by finding other shares through your broker or buying it on the open market.
#8 The Short-Squeeze
You have probably heard this term more often than you care to remember. A short squeeze is a market event when the price of a stock rises quickly, prompting shorts to “cover” — which means they must buy the stock in the open market to repay the shares they have borrowed.
This generates higher prices, which, in turn, prompts more people to sell and take a profit, which leads to brokers calling more loans, which then forces many short-sellers to go into the open market to cover their loans, and so on. Short squeezes can be ferocious, can last quite a while and can be very expensive.
#9 How to Cover
Believe it or not, you can end up owning a stock and shorting it at the same time if you are not careful with your instructions to your broker. When you call or go online to cover a short position, you must specify that this purchase is to cover the open short position. If you do not, you could end up buying the shares and have them sit in your account while also having an open short position on them.
Because short-sellers might find themselves exiting their positions in a hurry, it’s important to take the time to ensure that you issue clear instructions to your broker so that you get out when you want to.
#10 Dividends and Taxes
If you have borrowed and shorted a dividend-paying stock, you will receive the dividends, but you, in turn, must pay the original owner the value of those dividends.
Also, should you hold a short position for more than one year, well, tough luck — the IRS still treats capital gains as short-term gains. Ah, Uncle Sam is always reliable!
A Safer Way to Short Stocks
I’ve covered some of the things you will encounter when actually shorting a stock, but the real issue here is the level of risk you want to take on. A much-lower-risk way to short a stock is to buy a put option, and not borrow shares.