Can a stop-loss order be used to protect a short sale transaction?

By Investopedia Staff AAA
A:

The quick and simple answer to this question is yes.

The major difference between the stop-loss order used by an investor who holds a short position and one used by an investor with a long position is the position in which it is placed. The individual with the long position wishes to see the price of the asset increase, whereas the individual with the short position wants the price of the asset to decrease and would be negatively affected by a sharp increase. To protect against a large price increase, the short seller can use a buy-stop order, which is an order that will turn into a market order once the upper price has been reached. Conversely, the individual who holds the long position can set a stop-loss to be triggered when the price falls below a certain level.

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Watch: Stop Loss Order

For example, if a trader is short selling 100 shares of ABC Company at $50, he or she might set a buy-stop order at $55 to protect against a move beyond this price. If the price happens to rise to $55.25, the short seller's order would be triggered, resulting in the trader buying the 100 shares back near $55. A word of caution: on an extremely large increase in price, the buy-stop market order could be triggered at a substantially higher price than $55.

A different way that a short seller can protect against a large increase like the one mentioned above is by purchasing an out-of-the-money call option. If the price does experience a move upward, the trader can exercise his or her option to buy the shares at the strike price and then provide them to the lender of the shares used in the short sale.

(To learn more about short sales, see our Short Selling Tutorial. For more on stop-loss orders, read The Stop-Loss Order - Make Sure You Use It.)

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