Short selling is a common trading strategy employed by investors. It is, however, an extremely risky strategy due to the potential of unlimited losses on a trade. That is because short selling takes a bet on the decline of a stock price, so a loss occurs when the price of a stock goes up, and theoretically it can go up to an infinite price. Therefore, it is imperative to know how long to hold a short position for.
An investor should ideally hold a short position for as long as the investment is profitable and as long as one can reasonably expect the profits to increase in the future. However, there are a number of additional factors that can influence a short seller's decision on when to close out his or her position. The following are a few items to consider when deciding on when to exit a short position.
One factor to consider is interest charged by the broker on the loan of the shares to the investor's margin account. The longer the investor holds on to the short, the more interest charges accumulate. This becomes problematic if the amount of interest paid on the borrowed shares eliminates any profit realized from the short sale. The aim is to hold onto the short until the price of the stock drops, enabling the investor to buy back the borrowed amount of shares at a lower price and realize a profit from the short sell transaction, but interest charges must be figured into net profit.
Maximum Loss Threshold
Another important factor in determining how long an investor maintains a short position is how large a loss a trader is willing to sustain in the event the stock price rises rather than declines. The maximum acceptable loss should be decided before initiating any investment. Short sellers must have an awareness of the increased risk level involved in selling short as opposed to buying long. One method of ensuring an exit is placing a buy stop order. A buy stop order will signal a buy when a security hits a strike price that is above the current spot price.
Example of a Buy Stop Order
Say that Alex sells short 1,000 shares of Apple (AAPL) stock at $50. The trade is initially looking good as Apple's stock falls to $45; however, it soon goes back up and closes the day at $55. If Alex did not implement any sort of exit strategy, the trade would have lost $5 per share ($5,000). If Alex had instead put in place a buy stop order at $51, then the loss would only amount to $1 per share ($1,000).
An investor buying a stock can only sustain a maximum loss of 100% of his or her investment, but a short seller, while having a maximum potential profit of 100%, faces virtually unlimited risk, given that a stock price can theoretically rise to infinitely higher prices.
Hedging is a strategy employed to reduce risk in a trade by taking an offsetting position. It can reduce the amount of loss if the primary trade goes wrong. If the short position is being used to hedge an existing long position, then the investor may wish to hold on to the short for as long an opposing long position is maintained, or at least until the trader no longer considers the long position to be in danger of significant decline.
The Bottom Line
Short selling is a common trading strategy and can be profitable when managed correctly. Due to the high risk of unlimited losses, it is important that an investor carefully plan out his or her trade and know when to exit his or her short position.