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.

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.

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.

TheStreet Recommends

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) - Get Report

. 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.

Short Interest.

This represents the total amount of shares currently short. Short interest is reported to and disseminated by the stock exchanges, such as the

NYSE

(NYX)

and

Nasdaq

I:IXIC

on a monthly basis (see

"How Do I Find Short Interest for a Stock?"). This is an absolute number, which is not important in and of itself, but it is the first component in calculating the next metric, the short ratio.

Short Ratio.

The short ratio is sometimes referred to as the "days to cover." This ratio represents the amount of days (on average) that it will take for all short-sellers to cover ("buy-in") their short positions. It is calculated by dividing a stock's short interest by its average daily

volume. The higher the ratio, the more risky it is to short the stock, because it will take the short-seller a longer period of time to cover the short than for a stock with fewer days to cover.

Please be cognizant of the fact that the short ratio assumes that in the event that all shorts were to cover, they would do so to the exclusion of long buyers. Thus, in reality, it will take

more

days to cover all shorts than the short ratio implies.

Short Percentage of Float.

This represents the percentage of a company's available stock

float, which is already short. The greater this percentage, the greater the implication of the likelihood that the stock is a "crowded" short -- one that is heavily shorted. A higher short percentage of float also portends that the availability of stock to borrow could be in heavy demand and limited supply.

Don't get "short squeezed." Analyze these metrics carefully before you initiate a short sale.

Homework Time

This closes out my series on short-selling. By now, you should have a grasp of the essentials of what's involved in shorting stocks and how to do it. However, that should not preclude you from doing some homework:

  • For a short sale that you have on or are considering, identify the short interest, short ratio and percentage of shares short.
  • Observe a buy-in.
  • Observe a short squeeze.

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.