Canadian Securities Course (CSC) Level 1 Practice Exam

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What are the seven risks of short selling?

Borrowing shares
Insufficient liquidity
Regulatory compliance
Market volatility

The correct answer is: Borrowing shares

Short selling involves several risks due to its unique nature. Borrowing shares is a significant risk because it requires the short seller to obtain shares to sell in the market that they do not own. If the market price for those shares rises, the short seller faces potentially unlimited losses because they must eventually buy back the shares at the higher price to cover their short position. This operational aspect of borrowing shares and the obligation to return them creates a specific risk that needs careful management. The risks related to insufficient liquidity, regulatory compliance, and market volatility are also relevant to short selling but may not be as direct as the risk inherent in borrowing shares. Insufficient liquidity can hinder a short seller's ability to exit a position, regulatory compliance involves navigating the complex legal framework surrounding short selling, and market volatility can affect the timing and pricing of buying back the borrowed shares. However, borrowing shares fundamentally encapsulates the primary risk short sellers must navigate in their transactions.