Three Risks Every Short-Seller Must Know

So when short-selling, how does one manage this risk? If you are in a hedged or 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 buy 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 requires these two important conditions:

• Short-selling must take place in a 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 for the "stock borrow" (see "How Short Selling Works"). However, the 50% market value must be collateralized by cash or marginable securities .

Using the previous example, the following table illustrates the collateral requirements 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 to sustain the short sale if the stock continues to rise.