How to Protect Yourself When Shorting - dummies

How to Protect Yourself When Shorting

By Paul Mladjenovic

In going short, you aren’t worried about your stock falling (odds are you’re either relieved or happy). Instead, you’re worried about your stock going up. After all, the more that stock goes up, the more you stand to lose. Limiting your losses is more important when you’re shorting versus when you’re long. Why?

When you’re long on a particular stock, your potential gain is unlimited, but your loss is strictly limited to 100 percent of your investment. If you buy a stock at $35 per share, certainly the gain could be as high as the market takes the stock, but you know going in that the most you can possibly lose is $35 per share. If 100 shares became worthless, your loss would be $3,500.

However, in going short, the most you stand to gain is 100 percent, but your loss is potentially unlimited. Given that, you need something in place to limit your potential loss. Here are a couple of safety devices:

  • Buy-limit orders: Because you close out a short position by buying the stock you’re shorting, consider using a buy-limit order. If you just got into a short stock position at, say, $35 per share, put in a buy-limit order at 5 or 10 percent above that price, such as $36.75 ($1.75, or 5 percent, above the $35 price) or at $38.50 ($3.50, or 10 percent, above the $35 price).

    The amount depends on your comfort level. At 5 percent, you would limit your total loss to $175. At 10 percent, the total loss would be $350. Hey, no one likes losses, but small losses are preferable to larger ones. If you’re nervous about going short, then maybe you shouldn’t be shorting. Still, if you aren’t sure, then choose the closer limit price.

  • Call options: Because the danger of shorting stock is that the stock may rise, hedge against this rise and do something that would increase in value should the stock rise. Buying a call option on the same stock that you’re shorting is one way to do that.

Your first time shorting, limit how much you do until you get how it works. Don’t go short on 100 shares of an expensive stock. The stock prices of Apple and Google, for example, are usually in the triple digits. Instead, short a lower-priced stock and maybe do only 50 shares. That way, if the trade goes against you and you do experience a loss, it won’t hurt too badly. In addition, you learn a valuable lesson in short selling, which means you’ll be that much wiser next time.