Three Risks Every Short-Seller Must Know

Stock quotes in this article: AMZN  

So when short-selling, how does one manage this risk? If you are in a hedged hedging or arbitrage arbitrage position, then you already have "built-in" risk protection. This may not be perfect, but you are most likely protected against unlimited risk. If you are "naked" short-selling, which is short without any protection, then you must guard against unlimited risk. The best way to do this is to set a level of maximum tolerable loss and enter a good-till-canceled good- buy stop order stop-order to close the short in the event that the desired stock price level is attained.

2. Capital Risk

Because of the unlimited loss potential associated with short-selling, the Federal Reserve federal-reserve-system requires these two important conditions:

  • Short-selling must take place in a margin account margin-account.
  • The short sale must be collateralized by the short sale proceeds plus 50% of the market value of the short sale. The short sale proceeds are posted as collateral collateral for the "stock borrow" (see "How Short Selling Works"). However, the 50% market value must be collateralized by cash or marginable securities security.

Using the previous example, the following table illustrates the collateral requirements margin-requirement at various stock prices for a range of short sales of stock XYZ.

Stock Price Collateral
10 5
20 10
30 15
40 20
50 25
60 30
70 35
80 40
90 45
100 50

As we can see, as the price of the stock rises, not only does the short-seller lose money on the short sale, the short-seller will also have to post additional collateral. As a short-seller, it is possible that you can run out of capital capital to sustain the short sale if the stock continues to rise.

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