I often hear people mentioning that if you short a stock your potential loss is infinite. This is because the stock’s price is theoretically unlimited. When you short a stock (which is a bet that pays off when the stock goes down) you are basically trying to buy low, sell high, but you start by selling high first and buying it back low if/when the stock falls in price going forward.
For example if stock XYZ is trading at $50/share and you think it is going to go down, you could short sell it at $50/share. If it then starts to trade at $40/share you could “cover” your short position by buying the stock for $40/share. If XYZ were to increase however, then you would be losing money. Again, since it could keep going higher and higher your potential loss has no (theoretical) limit.
If the stock is option eligible, then all you have to do is purchase a call option on the stock to limit the loss. A call option gives you the right to purchase the underlying stock for a set price for a set time. So in the above example, you could purchase a call option on XYZ with a strike price of $55/share and your loss is now limited since if XYZ increased to $100 and your loss on the short position is huge, it is offset by the increase in value of your call option (which became In-The-Money when XYZ started trading above $55/share).
This is known as a “protected short sale” or a “synthetic put”. It is essentially the same thing as just buying a put in the first place – since owning a $50 put on XYZ would be profitable if XYZ fell below $50, but your loss is limited (to what you paid for the put in this case).
If you want to learn more about options, make sure to check out Mark Wolfinger’s blog.
Could you set a STOP limit on the shorted stock as well?
@Million Dollar Journey: Yes this is an alternative note that in a fast moving market once the stop price is reached and your order becomes a live limit order there is no guarantee that your limit price will be executed – hence there is a danger still.
I like using a stop order better. This way I can still limit my losses and not have to buy a call.
@Shaun – same basic response as above: in a fast moving market you may get your order filled at a price that is much different than what you were expecting (or not filled at all). It’s a tradeoff: you may pay more for the guaranteed limit on loss, or you can go for a cheaper alternative and perhaps not get the protection you were looking for.
i HAD SHORT STOCK ON EKC FOR 100 @39.6 and then i PURCHASED 100 @39.75 , CAN U TELL ME HOW CAN I GET OUT OF OCCURING LOSS FURTHER, I AM NOT SURE OF WHAT TO DO
If you had short sold the stock at 39.6 and then covered it (bought it) at 39.75, you are out of the trade. You lost a bit, but now you are no longer exposed to the movement of EKC.