There are no standardized regulation relating to just how long a short sale can last before being closed out. A short sale is a transaction in which shares of a company are borrowed by an investor and sold on the market. The investor is required to return these shares to the lender at some point in the future. The lender of the shares has the ability to request that the shares be returned at any time, with minimal notice. In the case of this happening, the short sale investor is required to return the shares to the lender regardless of whether it causes the investor to book a gain or take a loss on his or her trade.

Key Takeaways

  • There are no set rules regarding how long a short sale can last before being closed out.
  • The lender of the shorted shares can request that the shares be returned by the investor at any time, with minimal notice, but this rarely happens in practice so long as the short seller keeps paying its margin interest.
  • A broker can force a short position to be closed if the stock rallies strongly, causing large losses and un-met margin calls.
  • It is far more likely that the investor will close out the position before the lender will force the position closed.

Closing out Shorts

In practice, requests to return shares are rare, as the lender of the shares is a brokerage firm that has a large inventory of stock. The brokerage firm is providing a service to investors; if it were to call shares to be returned often, investors would be less likely to use that firm. Furthermore, brokerage firms benefit greatly from short sales through the interest they earn and commissions on the trades. There is also limited risk for the brokerage firms in a short sale transaction because of the restrictive margin rules on short sales.

In a short sale, brokerage firms lend shares out of their inventory, out of their clients' margin accounts, or they borrow them from another brokerage firm. If a firm lends out shares from one of its clients' margin accounts and that client, in turn, decides to sell their position, the brokerage firm will be required to replace the shares lent out from that client's account with other shares from their inventory, another clients' margin account, or from another brokerage firm. This situation does not impact the short seller.

Short selling can benefit skilled traders, especially when brokerages make stock available to be shorted at an interest rate just a few percentage points above the prime rate.

Forced Closings

However, there are some cases in which the lender will force the position to be closed. This is usually done when the position is moving in the opposite direction of the short and creating heavy losses, threatening the likelihood of the shares being returned in the future. In this situation, either a request will be made to return the shares, or the brokerage firm will complete the closing of the transaction for the investor. The terms of margin account contracts allow brokerage firms the freedom to do this.

Short covering can also occur involuntarily when a stock with very high short interest is subjected to a “buy-in”. This term refers to the closing of a short position by a broker-dealer when the stock is extremely difficult to borrow and lenders are demanding it back. Often times, this occurs in stocks that are less liquid with fewer shareholders.

While the lender of a short sale transaction always has the power to force the return of the shares, this power is usually not exercised. An investor can maintain a short position for as long as they are able to pay the required interest and maintain the margin requirements, and for as long as the broker lending the shares allows for them to be borrowed.

Short Squeezes

short squeeze involves a rush of buying activity among short sellers due to an increase in the price of a security. The increase in the security price causes short sellers to buy it back to close out their short positions and book their losses. This market activity causes a further increase in the security's price, which forces more short sellers to cover their short positions. Generally, securities with a high short interest experience a short squeeze.

For example, suppose the short interest in company XYZ Company is 50%. In this example, many traders are short from $50 due to poor earnings, and the stock is currently trading at $35. However, over the next quarter, the company reports stellar earnings and doubles in value to $70. Since many traders are short, they would need to cover their short positions to limit their losses; this creates buying pressure on the stock and causes the price to increase to $80, exacerbating the problem.

The Bottom Line

When an investor decides to short sell, it's because they expect that the market price of a stock will fall, enabling them to replace the shares in the future at a lower cost. If a stock doesn't drop in price quickly enough, it can cost the investor money. As a result, it is far more likely that the investor will close out the position before the lender will force the position closed.