Three Risks Every Short-Seller Must Know

In the previous two installments of The Finance Professor, I covered the mechanics of a short stock sale and the trading strategies that underpin short-selling. Now to close out this trilogy of short-selling lessons, I will focus on the inherent risks in short-selling and how you can manage these risks.

1. Trading Risk

When an individual "shorts" a stock, he or she is making a judgment call that the stock will decline in price. This is completely opposite to the position taken by a "long" buyer who anticipates the stock will rise in value .

Let's assume that stock XYZ currently sells at $50 per share . If you buy the stock, you will make one dollar for each increase in its stock price. Conversely, you will lose one dollar for every point that the stock drops in price. Your maximum loss is your initial investment of $50 (excluding any transaction fees), and your maximum gain is infinite. The return on a long stock purchase is depicted by the green line in the chart below (read on).

Alternatively, say that you short-sell XYZ at $50. You will make one dollar for each point that the stock declines. When the stock reaches a price of zero you will reach the point of maximum gain, $50. However, when you "short" a stock, you lose a dollar for each point rise in the stock price, so your potential loss is unlimited. This payoff potential is depicted by the red line in the chart below.

Returns of Long Buying vs. Short-Selling

Click here for larger image.