Short selling can be dangerous; it gets that way if you let a short position get away from you.
Any trade could cost you more than expected, but there’s an asymmetry in risk when you’re going short. Your maximum potential profit is the price at which you shorted the stock — because stocks can’t fall below $0 — but your maximum loss is, theoretically, unlimited.
That makes it imperative to properly manage risk in your short positions, being prepared to cover and close your shorts before they break out against you.
What are short positions in the stock market?
Stock short positions are a technique where a trader borrows shares of available stock from an investment firm to sell to another investor with the intent to buy them back within a short period of time, usually days or weeks. The goal is to borrow the stocks at a high price and buy them back at a lower price to then return to the broker.
Keep short positions in hand
Short stock positions are subject to a multitude of regulations and requirements, one of which is satisfying the minimum-margin requirement. Shorting is done in a margin account because you’re selling something you don’t currently own; by rule, you must hold at least 150 percent of the current market value of a short position at all times.
If you let a short position get out of hand and let losses mount, the chances that your capital becomes inadequate to satisfy margin requirements rises; you’re at risk of receiving a margin call, which is a broker’s demand to deposit additional capital or place eligible securities in the margin account to satisfy the minimum margin requirement.
If you fail to satisfy those requirements — which would violate the terms of the margin agreement you signed when opening the account with the brokerage — your broker could liquidate your position and buy back your shares at an unfavorable price. Because you might owe money to your broker if the stock is up significantly, there’s a big potential price to pay if you let a position run away from you.
As a trader, there’s never really a time when it’s okay to let a short positions stock get out of hand, but the risk is particularly acute when it comes to shorting. If you aren’t ready to give a short position your full attention and to monitor it closely at all times, don’t take the risk of shorting until you are able to give it your full attention.
Taylor Conway is the lead day trader at PennyPro.com. He is a short-term day trader of stocks and ETFs.