Using Stop Orders to Protect Profits on a Short Sale

Stop orders can be used to protect profits on a short sale. If you sell short a stock at $40 and the stock declines to $32, you might be reluctant to buy back the short position, hoping that the stock will decline even further. To protect profits against an unanticipated price increase, you place a stop order at $34 to preserve your $6 profit per share.

Similarly, use of a stop order can reduce the losses in an unfavorable short sale. If you sell short a stock at $15, you might place a stop order to cover a short position at $16. This strategy limits the losses should there be a rise in the price of the stock. Without a stop order, the investor potentially could face a large loss if the stock keeps going up in price.

With a long position in stocks, the most that an investor could lose is the entire investment (if the company goes bankrupt, and the stock falls to zero with nothing left for the shareholders). However, with short selling, if the price of a stock keeps rising, the losses theoretically could be unlimited.

Selling short may be risky for investors who do not have the stomach to watch the price of the stock turn in an unanticipated direction.

There are rules governing short sales on the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX), as well as for stocks on the National Association of Securities Dealers Automated Quotations (Nasdaq). Short sales may not be made when stocks are falling in price because this will exacerbate the price declines. On the exchanges, short sales may be made for a higher price than that of the previous trade, on an uptick, or for a price that is equal to that of the previous trade but more than the trade prior to that, on a zero-plus tick.

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