Short selling can be profitable, but it comes with risks that regular stock investing does not have. The most important thing to understand is that your losses are theoretically unlimited. This article covers all the major risks and how to manage them.
Risk 1: Unlimited Loss Potential
This is the biggest risk of short selling. When you buy a stock, the most you can lose is what you paid. If you buy $1,000 of stock and it goes to zero, you lose $1,000. That is your maximum loss.
Short selling is the opposite. When you short a stock, there is no limit to how high it can go. A $50 stock could go to $100, $500, or even $1,000. Your losses grow with every dollar the stock rises.
Example: Unlimited Loss in Action
You short 100 shares of XYZ at $50. You receive $5,000.
- If XYZ goes to $100: You lose $5,000 (100% loss)
- If XYZ goes to $200: You lose $15,000 (300% loss)
- If XYZ goes to $500: You lose $45,000 (900% loss)
Your losses can exceed your entire account if you do not use stop losses.
How to manage: Always use stop losses. Never risk more than a small percentage of your account on any single short position. Size your positions assuming the worst case scenario.
Risk 2: Short Squeezes
A short squeeze happens when a heavily shorted stock starts rising. Shorts panic and rush to cover, which pushes the price even higher, forcing more shorts to cover. It becomes a violent feedback loop.
Short squeezes can cause stocks to double, triple, or increase tenfold in days or even hours. The most famous example is GameStop in January 2021, which went from around $20 to nearly $500 in two weeks.
Warning signs of potential squeeze:
- High short interest: More than 20% of float sold short
- High days to cover: Short ratio above 5 days
- Low float: Fewer shares available means easier to squeeze
- Sudden positive news: Earnings beat, analyst upgrade, partnership announcement
- Unusual options activity: Heavy call buying can force market makers to buy shares
How to manage: Avoid crowded shorts. Check short interest before opening positions. Keep stop losses tight on stocks with high short interest. Reduce position size in squeeze candidates.
Risk 3: Margin Calls
Short selling requires margin. If the stock rises and your account equity falls below the maintenance requirement (usually 25% to 30%), you get a margin call. You must either deposit more funds or close positions.
Margin calls can force you to cover at the worst possible time, locking in losses you might have recovered from if you could have held on.
Margin Call Example
You have $10,000 in your account and short $20,000 worth of stock.
- Initial margin requirement (50%): $10,000. You meet this.
- Maintenance margin (30%): 30% of position value
- Stock rises 50%: Position now worth $30,000
- Your account balance: $10,000 - $10,000 loss = $0
- Required maintenance: $30,000 x 30% = $9,000
- You have $0 but need $9,000 = margin call
How to manage: Keep extra cash in your account beyond minimum requirements. Monitor your margin level daily. Use stop losses to exit before margin calls happen.
Risk 4: Share Recalls
When you short a stock, you borrow shares from someone. The lender can recall those shares at any time. If your broker cannot find replacement shares, you must cover immediately at market price.
Recalls are more likely when:
- The stock becomes hard to borrow
- Short interest spikes
- The stock rises sharply
- Near dividend dates or corporate actions
How to manage: Prefer easy to borrow stocks. Avoid stocks where borrow is already tight. Monitor your broker notifications about share availability.
Risk 5: Borrow Costs
You pay interest to borrow shares. For easy to borrow stocks, this might be 0.25% to 1% annually. But hard to borrow stocks can cost 20%, 50%, 100% or even higher.
High borrow costs eat into profits and can make even correct predictions unprofitable.
Borrow Cost Impact
You short $10,000 of a hard to borrow stock with 50% annual borrow rate.
- Monthly cost: $10,000 x 50% / 12 = $417 per month
- The stock must fall at least 4.17% per month just to break even
- If you hold for 3 months, you pay $1,251 in borrow fees
How to manage: Always check borrow fees before opening a short. Factor fees into your profit target. Avoid holding hard to borrow stocks for extended periods.
Risk 6: Dividend Payments
If you are short a stock when it pays a dividend, you must pay the dividend to the share lender. This reduces your profit or adds to your loss.
For high dividend stocks, this cost adds up quickly. A 4% annual dividend means you lose 1% of your position value every quarter.
How to manage: Check dividend dates before shorting. Consider closing shorts before ex-dividend date. Avoid shorting stocks with high dividend yields unless you expect a big drop.
Risk 7: Buy-ins
If shares become unavailable and your broker cannot find replacements, they may force close your position (buy-in). This can happen at any time without warning, often at unfavorable prices.
Buy-ins are more common during high volatility, around corporate actions, and in thinly traded stocks.
How to manage: Stick to liquid stocks with high trading volume. Avoid shorting around major corporate events. Keep position sizes reasonable.
Risk 8: Gap Risk
Stocks can gap up overnight on news released after hours. Your stop loss will not protect you from gaps. If you are short at $50 with a stop at $55, and the stock opens at $70 on buyout news, you eat the full loss.
Gap Risk Example
You short XYZ at $50 with stop at $55 (10% risk planned).
- After hours: Company announces acquisition at $75
- Stock opens at $75 the next day
- Your stop triggers but fills at $75, not $55
- Actual loss: 50% instead of planned 10%
How to manage: Size positions for gap risk, not just stop loss risk. Close shorts before earnings or major announcements. Consider using options to define maximum loss.
Risk 9: Regulatory Risk
Regulators can ban or restrict short selling. During extreme market stress, regulators have implemented temporary short sale bans on certain stocks or entire sectors.
If you are short when a ban is announced, you may be forced to cover or prevented from shorting more.
Position Sizing for Short Selling
Because of these risks, short positions should typically be smaller than long positions:
- Consider limiting individual shorts to 2% to 5% of portfolio
- Limit total short exposure to a percentage you can handle if everything squeezes
- Account for gap risk when calculating position size, not just stop loss distance
- Have a plan for worst case scenarios
Monitor Your Short Risk
Pro Trader Dashboard tracks your short positions, alerts you to high borrow costs, monitors short squeeze risk, and helps you stay on top of margin requirements.
Summary
Short selling carries risks that long positions do not have: unlimited losses, margin calls, squeezes, recalls, borrow costs, and gap risk. Understanding these risks is essential before shorting any stock. Use stop losses, size positions conservatively, monitor borrow costs, and always have a plan for when things go wrong.
Learn more about short squeezes or see when to cover short positions to manage your exits.