What Happens if a Short Seller Cannot Cover? (Explained)

What happens if a short seller cannot cover? This is a question that many people are asking and for good reason. The stock market can be a very volatile place and when you are short selling, you are essentially betting against the market. 

In this article, we will explore what can happen if you cannot cover your short position. We will also look at some of the reasons why someone might not be able to cover their shorts, and what happens in those cases. 

Reasons why a short seller cannot cover 

If you are a short seller, there are a couple of reasons why you might not be able to cover your position. 

The first reason is liquidity. If no shares are being traded, then you will not be able to cover your position. This can happen if the stock is extremely illiquid, and the trading volume is nonexistent. 

It is also possible that the number of shares short is higher than the float of the company, or the shares that can be traded. This has happened in the past in some of the largest short squeezes in history.

Another reason why you might not be able to cover is if you placed a limit order bid that was too low. This means that you were trying to buy the shares back at a lower price than what they were currently trading at, and no one was willing to sell them to you at that price. 

This can happen for a number of reasons, for example, stocks that are very volatile can change their price frequently.

What happens if you can't cover your naked short? 

When it comes to a naked short, the consequences can be even more severe. A naked short is when you sell a security that you do not have in your possession, in the hope that you will be able to buy it back at a lower price and thus turn a profit. 

However, if the price of the security goes up instead of down, then you will be forced to buy it at a higher price to cover your position. This can lead to massive losses, and in some cases, even bankruptcy. 

For example, let's say you sell 100 shares of Company XYZ at $20 per share, but the price of the stock then goes up to $30 per share. You will then have to buy the shares back at $30 per share to cover your position. This means that you have lost $1000 on the trade. 

If you are unable to cover your short while the stock keeps rising you could seriously lose a lot of money. This is one of the major risks of shorting stocks.

What can you do to avoid this situation? 

There are a few things that you can do to avoid getting into a situation where you cannot cover your short position. The first thing is to make sure that you are only shorting security that you are comfortable with. 

This means that you should have done your research, and you should understand the risks involved. 

Another thing that you can do is to place a buy-stop order, which is nothing more than a stop-loss for short positions. When you enter into the short position, you can place a buy-stop, which is an order to buy the stock if it reaches a certain price. This can also help you to prevent losses when shorting a stock.

This will ensure that you do not lose more money than you are comfortable with, as you will only be able to sell the shares at a price that you are happy with. 

Finally, you can always close out your position before the market closes. This way, if the price of the security does start to go against you, you can limit your losses by buying the shares back at a lower price. 

Do short-sellers have to cover? 

Yes, but there is no specified time limit. This means that a short-seller can hold their position indefinitely. However, if the price of the stock goes up, the short-seller will have to buy the stock at a higher price to cover their position. 

When do short sellers have to cover? 

Short sellers will have to cover when the stock price goes up above a certain threshold, to limit losses. However in theory a short seller is not forced to cover any of his short positions unless his margin requirements are not sufficient and the broker demands him to cover.

Short sellers may also be forced to cover if the person who lent the shares asks for a share recall. This means that you will have to return the borrowed shares to their rightful owner.

Lastly, short-sellers may choose to cover voluntarily if they are no longer convinced that the stock price will go down. They may also cover if they need the money for other purposes. So there are a few different reasons why short-sellers might have to cover. 

It all depends on the stock price and the short seller's own personal situation. 

What happens if you cannot cover your short position? 

If you cannot cover your short position, then you will be "stuck" in that position. This means that you will still owe the shares to whoever you borrowed them from, and you will have to continue paying the daily interest charges on the loan. 

If a short seller is unable to cover, they may be subject to a margin call from their broker. A margin call occurs when the value of an investor's account falls below the maintenance margin requirements. 

If the investor does not meet the margin call, their broker can then sell the securities in the account to cover the loan. This can obviously have disastrous consequences if the market continues to move against the short seller - the position can quickly become "un-coverable". 

Short sellers should always have a plan in place to cover their positions if the market moves against them, to avoid being forced into a difficult and possibly costly situation. 

Conclusion

Short selling is a risky investment strategy and should only be undertaken by experienced investors. Short sellers should have a plan in place to cover their positions if the stock price rises unexpectedly. Otherwise, they could face serious financial consequences.