Can a stop-loss order protect a short sale?

The quick and simple answer to this question is yes.

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. The individual with the long position wants the price of the asset to increase and would be negatively affected by a sharp decrease. The individual with the short sale 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 individual who holds the long position can set a sell order to be triggered when the asset hits the execution price.

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.

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