Three Risks Every Short-Seller Must Know

A popular class of hedge fund is one which is referred to as the "long-short fund." Long-short funds employ a strategy of purchasing a portfolio of stocks and then hedging those stocks with a portfolio of short sales. A pure long-short fund will be equal dollar long vs. equal dollar short (or 100/100). The long stocks are purchased for cash and will then be utilized at 50% margin value to collateralize the short positions . A variation of this theme was the "130/30," where the strategy was to be net long but to leverage up the long position by 30% and hedge with 30% of short sales, which were collateralized by the net marginable value of the long stocks.

Here is the problem with these strategies: If you sustain large losses on one side of the trade, then you will no longer have enough equity in the account to satisfy the margin requirement for the combined strategies. These long-short hedge funds racked up tremendous losses this past summer of volatility and were forced to liquidate in order to meet margin requirements. This was a result of either the shorts losing money while the longs were underperforming or both the longs and the shorts were losing money.

How can you hedge this potential loss of capital? The same basic rules of risk management apply for leverage for on the short side of the market as they do on the long side. Over reliance on leverage can result in rapid deterioration of one's capital. So the best advice here is to use margin and leverage sparingly and wisely (see "Understanding Leverage").

3. Borrowing Risk

By now, we know that obtaining a stock borrow is critical to achieving a short sale. One of the biggest risks to a short-seller is the loss of that stock borrow.

If the supply of stock available to borrow dries up, then short-sellers might be required to "cover" their shorts or be subject to automatic "buy-ins" by the stock lender and selling broker (see "How Short Selling Works"). Systemic rapid short-covering is referred to as a "short squeeze." Short squeezes occur when shorts are forced to cover because of industrywide loss of available stock to borrow or when a bullish event causes a cascade of short-covering.

To see an example of a short squeeze that is currently occurring in the market, observe Amazon.com (AMZN Quote). Amazon.com stock is selling at nosebleed valuations because the momentum traders keep pushing the stock higher, while the shorts are faced with high levels of short interest and "days to cover."

As a short-seller, before you enter into a short position, there are several metrics which you should be familiar with and must incorporate into your trading analysis. The following is a breakdown of those metrics.