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.

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.)

RELATED FAQS

  1. What are the risks associated with investing in telecommunication stocks

    Read about some of the risks associated with investing in telecommunication stocks, including several that are specific to ...
  2. What is liquidity risk?

    Learn how to distinguish between the two broad types of financial liquidity risk: funding liquidity risk and market liquidity ...
  3. What does the gearing ratio say about risk?

    Find out why lenders and investors pay close attention to a firm's gearing ratios, and why both too much and too little borrowing ...
  4. What are the most common momentum oscillators used in options trading?

    Read about some of the most common technical momentum oscillators that options traders use, and learn why momentum is a critical ...
RELATED TERMS
  1. Investment Income Ratio

    The ratio of an insurance company’s net investment income to ...
  2. Adjustable Feature

    Contract language that allows adjustments to be made to the premium ...
  3. Development To Policyholder Surplus

    The ratio of an insurer’s loss reserve development to its policyholders’ ...
  4. Overall Liquidity Ratio

    A measurement of a company’s capacity to pay for its liabilities ...
  5. Reinsurance Recoverables to Policyholder Surplus

    The amount of incurred losses covered by reinsurers compared ...
  6. Net Premiums Written To Policyholder Surplus

    A ratio of an insurance company’s gross premiums written less ...

You May Also Like

Related Articles
  1. Options & Futures

    Stock Futures vs Stock Options

  2. First time stock investors may ask, is there any way to buy insurance on stocks to prevent losses?
    Options & Futures

    Stock Safety: Top 3 Ways to Limit Your ...

  3. Options & Futures

    Applying Binary Options To Equity Markets

  4. Investors can use derivative securities to effectively buy insurance on their individual holdings or on their portfolio as a whole.
    Options & Futures

    Can You Buy Stock Insurace? 3 Strategies ...

  5. With more ETFs to trade, the risks associated with these investments have grown. To mitigate these risks, ETF options are a hedging strategy for traders.
    Mutual Funds & ETFs

    ETF Options Hedge Risk of ETF Trades

Trading Center