Many stock traders know how to go long but they are afraid of shorting stocks considering it to be risky. Short selling stocks is a strategy that works very well in a falling markets. Just like any other stock trading strategy, you should know the risks and learn how to manage that before you think about taking profit. If you can do that you can make a fortune short selling stocks.
So what are the risks of shorting stocks? The number one risk is that theoretically, your potential loss can be infinite. A stock price can fall to at most zero but cannot go below that. But a stock price can rise as high as infinity at least theoretically speaking. So, in case of shorting stocks, the potential loss can be real high if the stock price starts to rise and rise. Of course, it won’t reach infinity. That is not practical but your loss can be high. You need to learn how to manage this potential huge loss risk.
The other risk inherent in short selling stocks is known as, “Short Squeeze.” It happens when the stock price falls and suddenly turns around and starts rising again. This can happen on the release of a sudden breaking news about the good earnings reports or a major breakthrough made by the company’s research department that the market suddenly turns around.
When this happens and if there are many short sellers in the market, they would all want to get out as quick as possible. No body was expecting such a good breaking news. But now that that has happened, the best possible thing is to exit. When everyone tries to exit at the same time, this introduces the short squeeze, with so many buyers desperate to buy back the stock, the stock price is naturally going to go high and high.
So how do you manage these two short selling risks? By using an options trading strategy, you can reduce the risk of short selling. Buying an out of the money CALL will give you the protection, limit your risk and provide a natural stop loss. This CALL on the underlying stock will confidently let you go short and take advantage of the downside profit potential.
A second advantage of this CALL options strategy is that you can roll over your position as long as you want. So if the July Call is near expiration but you still want the short position open, you can sell the July CALL and buy the October or January CALL.