Shorting the Stock of a Company That Goes Bankrupt

What happens when an investor maintains a short position in a company that gets delisted and declares bankruptcy? The answer is simple—the investor never has to pay back anyone because the shares are worthless.

Companies sometimes declare bankruptcy with little warning. Other times, there is a slow fade to the end. A short seller who didn't buy back the stock before trading stopped may have to wait until the company is liquidated to take a profit.

However, the short seller owes nothing. That is the best possible scenario for a short seller. Eventually, the broker will declare a total loss on the loaned stock. At that point, the broker cancels the short seller's debt and returns all collateral.

Key Takeaways

  • A short seller who doesn't buy back the stock before bankruptcy may have to wait until the company is liquidated to take a profit but never has to pay back anyone.
  • It is essential to realize that it is brokerages and not the companies themselves that allow short selling.
  • A short seller makes a profit by borrowing shares, selling them on the market at a specific value, and then repurchasing the shares at a lower price.
  • Short selling is considered a risky way to profit from a declining stock; consequently, most individual investors avoid it.

Why Would a Company Let You Short Its Stock?

A short seller's ability to profit from a company's bankruptcy naturally raises other questions. How are investors able to short stocks in the first place? Don't companies have a duty to maintain value for their shareholders? Shouldn't they be doing something to stop short sellers from bankrupting their company?

The truth is that the management at failing firms will often blame short sellers for their misfortunes. Occasionally, policymakers in some countries will even listen to their pleas and temporarily ban short selling during a period of financial distress. For example, several EU states temporarily banned short selling during the coronavirus crisis in March 2020.

Usually, companies cannot restrict brokerages from letting investors short stocks. It is essential to realize that it is brokerages and not the firms themselves that allow short selling. No company actually wants investors to short sell its stock.

Why don't governments ban short selling forever? The main argument is that bears, who believe a stock's price will fall, have useful information to contribute. Short sellers can be particularly helpful in reducing the impact of financial bubbles. By short selling near the top, the short sellers reduce the maximum prices reached when asset prices go too high. Furthermore, short sellers must eventually buy back shares. That creates some buying later on when most investors are afraid to buy. As a result, short sellers can actually reduce losses after a market crash.

How Short Selling Works

Understanding the short selling process also helps to explain how it can help markets work more efficiently. When investors short sell stocks, they borrow the shares, sell them on the market, and then collect the proceeds as cash. For example, let's say an investor wants to short sell one share of ABC Bank. That investor can borrow one share of ABC bank for $100 and sell it for $100. The stock then drops to a price of $70. The investor can then buy a share for $70 and return it, netting $30 in the process.

If investors want to get out of short positions, they must buy back the same number of shares to repay the loans. Those investors who go short provide liquidity to markets and prevent stocks from being bid to ridiculously high levels through hype and excessive optimism. When they buy to close their short positions, they stop prices from falling even lower. Buying to close is the only way to exit a short position unless the firm goes bankrupt.

Why Short Selling Is So Risky

Despite the benefits that short selling can provide to the market, it is not appropriate for most retail investors. Short selling is not for the novice investor because, in theory, there is no limit to the amount that one can lose. A share selling for $10 can go up to $100, $200, or even $2,000. The short seller must eventually repurchase it at the market price, losing over 1,000% or even over 10,000% of the initial investment.

In actual practice, short sellers will face margin calls from their brokers before losses become greater than the liquidation value of the account. But rare cases have created a scenario where the stock price has gapped much higher overnight and the investor’s account is completely wiped out.At that point, the short seller must put more money into the position to maintain it or close the position. Brokerages will not allow investors with only $10,000 to build up losses of $100,000 or $1,000,000.

A short seller facing a margin call is almost always better off closing the position.

On the other hand, taking a long position and simply buying stock has limited risk. One cannot lose more than the amount initially invested. Therefore, it is far safer to buy and hold a stock than maintain a short position.

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