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A stop-loss is a function that automatically executes a trade whenever the price reaches a certain level. Usually traders use stop-losses to take profits whenever the value of an investment starts to dip. But there’s another way to use these automatic trades: to prevent excess losses from a short trade.
Key Takeaways
- A short sale is a trade where a trader bets that the price of a stock or other security will go down.
- Short sellers can use stop-loss orders to close their positions automatically if the price gets too high.
- A typical stop-loss for a short sale will use a buy-stop order to sell the asset when the price rises to a certain level.
Understanding Stop-Loss Orders and Short Sales
The major difference between a stop-loss order used by an investor who holds a short sale and one used by an investor with a long position is the direction of the stop’s execution. A trader with a long position wants the price of the asset to increase and would be negatively affected by a sharp decrease.
However, a short seller wants the price of the asset to decrease and would be negatively affected by a sharp increase. To protect against a sharp rise in asset price, the short seller can set a buy-stop order, which turns into a marketable order when the execution price is reached. Conversely, the trader with a long position can set a sell order that is triggered when the asset falls to the execution price.
Unlike ordinary stock investments, the potential gains from a short sale are limited, but the potential losses are infinite.
Example of a Stop-Loss for a Short Sale
For example, if a trader is short selling 100 shares of ABC Company at $50, they might set a buy-stop order at $55 to protect against a move above this price level. If the stock rallies to $55, the stop would be triggered, buying the 100 shares near the current price. A word of caution: in a fast-moving market the buy-stop order could be triggered at a substantially higher price than $55.
Another way that a short seller can protect against a large price increase is to buy an out-of-the-money call option. If the underlying asset rallies, the trader can exercise their option to buy the shares at the strike price and deliver them to the lender of the shares used for the short sale.
How Do You Hedge a Short Sale?
One straightforward way to hedge a short sale is to buy an out-of-the-money call option whose strike price is slightly higher than the current price. If the stock price rises, the investor can execute the option, allowing them to buy the stock at the lower price and close out their position. Although the investor has to pay a premium for the option, it protects their position from potentially higher losses.
How Do You Use a Stop-Loss to Protect a Short Sale?
Short sellers can protect their positions by setting a buy-stop order with an execution price somewhat higher than the current price. If the underlying stock increases enough to reach the execution price, the trader’s shares are automatically sold, which can be used to close out their position while limiting their losses.
What Are the Risks of Stop-Loss Orders?
One major risk of stop-loss orders is that they are not guaranteed execution at the price that you want. If the price changes suddenly, the trade may execute at a much worse price than the trader intended, leading to greater losses. Moreover, if the price remains volatile, the trader could miss out on potential gains from a rebound.
The Bottom Line
Stop loss orders are generally used in long trades, to automatically sell an asset when its price begins to fall. However, they can also be used by short-sellers to protect their positions against price gains. There are some disadvantages to this strategy, and many short-sellers prefer to hedge with options instead.
