What Are the Downside Risks of Shorting a Stock and How to Mitigate Them

So you've probably heard that shorting stocks is extremely risky, right? My name is Adrian Reid. I'm the founder of Enlightened Stock Trading. In this video, I'm going to explore what the downside risks are to shorting a stock and whether or not and how you can mitigate those risks so you can trade on the short side without losing sleep at night. But before we go any further, make sure you hit the subscribe button and give this video a thumbs up so that you get notified of all of my future videos because I've got new trading content coming out all the time and I don't want you you to miss a thing. So what are the downside risks of shorting a stock? Well, there's basically three real scenarios or events that you need to be concerned about. The first one is overnight gaps. If you're short a stock, the worst thing that can happen is that the stock gaps up as it moves against you overnight when there's no chance to get out, no chance for your stop loss to, to get you out to safety. The second scenario after gap ups is acquisitions. And this is basically, it manifests in the same way when a company that you're short is acquired or a takeover is announced. Typically that happens after market hours and the following morning the price of the stock will gap up to the price or to just under the price of the takeover offer. So both scenario one and scenario two, the gap up and the acquisition manifest the same way. There's a big gap against you overnight that causes you to lose money. The third scenario that really can be a huge problem in short selling a stock is when you get stuck in a short squeeze. Now if you've been trading for a little while, you may remember not so long ago there was a huge short squeeze in GameStop, which is a U.S. stock, and that stock just basically skyrocketed. There were a whole bunch of hedge funds that were short this stock and a large number of retail traders banded together and manufactured a short squeeze which pushed the price up, which hit some stop losses and caused the hedge funds to have to buy back their short position. And basically in a short squeeze, the share price skyrockets very, very quickly. And as a short seller, it's hard to get out without losing a lot of money. So they're the three things that you really have to worry about the most.

In terms of downside risk when you're shorting a stock. So how can we manage them? What can we actually do? Is it safe to short sell stocks when we've got these risks hanging over us. Well, absolutely, yes, you can short sell without losing your shirt, without blowing up your account. Let me give you a couple of techniques, a couple of hints for how you can manage this going forward. The first one is, whenever you're trading stock short, you want to trade with small, equally sized positions. Now, when, when a stock moves against you, let's say you go short a stock at 100, it can go to 150, 200, 300, 500, $1,000 a share. Theoretically, generally that won't happen. But if you look at the chart of GameStop. Actually, let me pull that up for you right now. I'm just going to grab my charts here. Let's go to.

Here we go. Let's go to.

GameStop. Oops. There we are. All right.

And I'm on a log scale here, so this doesn't look very impressive. Let me change it back to a linear scale and you can see what happened. So if I zoom in here, you can see GameStop was basically.

Trundling along at almost zero. So like a dollar, just over a dollar here for months and months. And there are a lot of hedge funds and so on that were short. This stock was heavily shorted. And then this movement started to gain traction about forcing a short squeeze on GameStop. And the reason this happened is there was a lot of a very high short interest in this stock. So that means it was basically ripe for a short squeeze sort of situation. And you can see here, as it started to happen, the price sort of edged up and edged up, but then it really took hold and the stock ended up going from just around a dollar and it peaked at over $120. So if you were short here and you basically were completely asleep at the wheel and you didn't get out, you didn't have a stop loss, you could have lost a huge, huge amount of money. So the short squeeze is really dangerous if you're not being attentive to your positions. And even if you are, you can see some of the overnight gaps here. Check this out on this. On the 26th of January, it closed at 36, 99. And on the 27th of January it opened at 88. So it closed at just about $37 and it opened the next day at 87. So they're the sort of gaps that you really want to worry about. Now, why am I telling you about this when I'm talking about position sizing? Here's the thing.

Just imagine you had a big short position in a stock like that. That ended up in a short squeeze with huge overnight gaps and a big run up. If you had a large position, if you were being aggressive on that particular stock because you thought it was a dud stock and it was going down, then your potential loss is huge. But if you have very small, equally sized positions, and many of them, as in you're shorting lots of different stocks, the downside risk of those short squeezes and the overnight gaps is much more contained. So because of the risk of.

Gaps up and short squeezes, you really want to make sure every position is small. For, for me, I wouldn't have any short position bigger than 5% of my account in terms of exposure and I would have a stop loss that would aim to limit my normal risk to much less than that. In fact, 5% is probably aggressive. When you look at things like this, like the way the gamestop moved so many small, equally sized positions, I don't use risk based position sizing on the short side. So risk based position sizing is, is where you have your entry price and your stop loss and you use that distance as in your normal risk, your 1R risk, if you like in Van Tharp, speak to size your positions to say 1% of your account or half a percent of your account risk on that trade. The reason I don't do that is because if your stop loss is too tight, you end up with a big position. And on the short side, the damage is done by the exposure of your trade. So if you have a big position, even if your stop loss is small and that big position gaps against you, then your loss is way bigger than what you expect. So I position size based on exposure, not based on my stop loss. I do use a stop loss on a short side. But your position sizing needs to think beyond the stop loss because it can blast through your stop if it gaps up overnight. So that's one thing. Small evenly sized positions. Second, one second strategy use a stop loss. When you're on the short side, the risks are very, very high if the stock continues to move against you. If you, if something happens to you while you're short, like let's say you get rushed to hospital, you have a car accident, you get sick, or you just plain distracted, you want to have a stop in the market because the damage to your account can be so big. On the long side, it's not quite so bad because let's say you buy a stock at $100 a share, what's the worst that can happen? It goes to zero. So you lose your $100 a share. But on the short side, if you short a stock at $100, the worst that can happen is uncapped. It can go to 200, 300, 500, and as you saw in GameStop, a dollar stock can end up over 100 in the right conditions. So you want to have a stop loss in the market just in case something happens to you so that you don't suffer from unlimited losses. I don't believe you need to be scared as a trader of the unlimited loss of trading on the short side. I just think you need to be diligent. You know, you need to have a good system, it needs to be back tested, you need to have a stop loss, you need to have small, equally sized positions. But what else can you do in order to manage your risk? The next thing that you should do is on the short side, I only trade highly liquid stocks. It's very tempting to see some small, small cap, crappy companies.

Where the share price is trending down and you want to short them. But the risk is for a small cap stock, a small price announcement or a takeover announcement can really push the price a long way against you. So on the short side, I'm really looking for very high liquidity, very high average daily turnover in my stocks. Because that's what helps you, it helps mitigate the downside. Because a large cap blue chip company won't tend to double, triple, quadruple overnight, but a penny stock can very, very easily. And it happens in fact quite often. So you don't want to, I wouldn't want to be short small cap stocks like that. So I'm only shorting highly liquid stocks. The next thing I like to do is.

I emphasize the short side when the market is going down, when the broader market is going down. So, so most of my short selling systems turn on only when we're in a bear market. That means typically when the broader index is below its 200 day moving average. Because bad things tend to happen below the 200 day moving average, good things tend to happen above the 200 day moving average. So if you want to reduce your risk of getting whacked by an adverse move and tilt the odds in your favor when you're trading on the short side, then think about using a regime filter that keeps you in the short side only in a bear market. In a bull market keeps you out. Because in a bull market the money is on the long side. Yes, you can make money short, but you've got to be much more nimble, much more aggressive and short term in your trades. Whereas in a bear market you can short stocks that are falling, hold them for a couple of weeks and set a profit target and typically make pretty good money. So index regime. The final strategy that you can use to diversify to manage your risk on the short side, manage your downside risk is to use system diversification. Now no one system is perfect and no parameter values that you select for one system are perfect. If you've got a back tested trading system for the short side and let's say you chose a 200 day moving average and a 40 day breakout and a 30% stop loss and so on, if you chose all of those things, you can trade that. If it back tests well, that's great. But having a few variations of that trading system is also a really good idea because your one parameter set that you've chosen from the past and backtested is not going to be the best parameter set going forward. We don't know what the best parameter set in the future is going to be. So I like to diversify on the short side, diversify my parameters in my systems and to make sure that, you know, if the market in the future is a little bit different than it is now, then you know, I've got a variation of my system that might give me a chance to make more make money. So I don't want to rely on just one set of systems. I don't want to expose myself too much to any one stock. I want lots of, lots of small, equally sized positions. I always use a stop loss. I trade highly liquid stocks and I trade primarily on the short side when the broader index is heading down. Those are things you can do to mitigate the downside risk in trading short. I don't want you to be afraid of short selling. It is something, a strategy that adds huge value to the portfolio. Because what happens is on the long side you can make great money in a bull market. In a bear market, yes, you can scratch out some returns on the long side, but you'll do far better overall if you can make money in a bear market as well as a bull market. And the best way to make money in a bear market is have a short strategy that gets you in when the market turns and rides the market down, takes profit at the bottom or near the bottom, and then you go back in. On the long side. That's a great way to smooth your equity curve, to diversify your account and to also hedge some of your longs that maybe you're still long as the bear market starts to emerge. So I hope that helps. That's how I think about the downside risks and mitigating them in a bull in a bear market for a short selling of stocks. My name is Adrian Reed. If you've got any questions about short selling, post them below this video and I'll help you out. This is enlightened stock trading. I'll see you in the next video. Bye for now.

Sam.