The perils of short-selling can be summarized in a simple statement: “Upside is limited to 100% but downside is unlimited”. Some of the famously successful short-sellers such as George Soros are known to use strategies that limit the downside risk to less than the size of the initial short position while increasing the upside potential over 100% by using variations on the following strategy:
- Set up stops at higher prices to close parts of your position, if the stock moves against you. The amount to close should be such that the size of the position remains at ~1%.
- Set up entry points at lower prices to add to your short position, if the stock goes down. The amount to add should be such that the size of the position remains at ~1%.
An example follow:
- Say your portfolio size is $100K and you want to start a 1% short position on XYZ stock priced at $10. So, you short 100 shares at $10.
- If the stock doubles, close the short position and your loss will be $1K, or 1% impact to your portfolio. So, your losses are capped at 100% of your initial position. The same strategy can be used to close parts of the position at more granular points rather than waiting for the stock to double before closing. That can reduce the downside risk even more. In our example, if you dispose 50% of the position when the stock increased by 50% ($150) and disposed the rest when the stock doubled, your total loss is 75% of your initial position.
- If the stock drops 50%, increase the short position so as to keep the size of the position relative to the portfolio size constant at 1%. This ensures that the portfolio impact will be more than 1%, or more than 100% of your initial short position. In our example, if the stock drops by 50% to $5, sell short another 100 shares so that the size of your short position remains at 1% of your portfolio (200 shares * $5 = $1K or 1% of your portfolio of $100K). At this point, you netted a total of $1.5K by selling short the 200 shares. Now, if the stock goes to zero, your profit would be $1.5K or 150% of your initial short position for a 1.5% overall portfolio impact. The strategy can be used in a more granular fashion to increase the return potential even further.
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