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Three Risks Every Short-Seller Must Know

10/18/07 - 11:55 AM EDT

Scott Rothbort

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.

At the time of publication, Rothbort was had no positions, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.


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