When you’re shorting stocks, the last thing you want to happen is a forced buy-in. Once you sell a stock short, there is the potential risk of being forced to buy back and close out the short position, due to regulatory reasons. Let’s look at what causes a forced buy-in.
Reasons for a forced buy-in
Under U.S. Securities and Exchange Commission (SEC) Rule 204 — which covers naked short selling and extended fails to deliver by sellers of stocks — brokerage firms are obligated to make delivery with buyers in order to satisfy settlement requirements. If you have an open short position on a stock, and that contributes to your brokerage firm’s inability to make a delivery to buyers, you could potentially be forced out of your position.
When there’s a lack of inventory, and market participants purchase shares of the stock shorted, your broker has three business days from the transaction date — when the market participants purchased the shares you sold short — to deliver shares to the other party. If the brokerage can’t deliver sufficient shares, it could issue a forced buy-in notice, which would cause you to close out your position to make delivery.
Similarly, every now and again, the lender of shares being sold short might recall those shares; you’d be forced, in these cases, to buy back shares and close out your position and return those shares to the original lender. In these cases, you would not receive any prior notice. Another situation that could force you to close out a position is if your broker is unable to borrow sufficient shares to complete your trade; in these cases, brokerages issue notices informing traders that a forced close-out might be necessary.
You can’t really control forced buy-ins, but it’s not something you want to experience when you’ve got an open short position because you could be closed out at unfavorable prices. To minimize the chances of running into a forced buy-in, avoid stocks with a high short interest and a low float.
Jeff Williams is the lead trader of PennyPro.com. He is a short-term trader of stocks under $10 a share.
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