I often hear people mentioning that if you short a stock your potential loss is infinite. This is because the stock’s price is theoretically unlimited. When you short a stock (which is a bet that pays off when the stock goes down) you are basically trying to buy low, sell high, but you start by selling high first and buying it back low if/when the stock falls in price going forward.

For example if stock XYZ is trading at $50/share and you think it is going to go down, you could short sell it at $50/share. If it then starts to trade at $40/share you could “cover” your short position by buying the stock for $40/share. If XYZ were to increase however, then you would be losing money. Again, since it could keep going higher and higher your potential loss has no (theoretical) limit.

If the stock is option eligible, then all you have to do is purchase a call option on the stock to limit the loss. A call option gives you the right to purchase the underlying stock for a set price for a set time. So in the above example, you could purchase a call option on XYZ with a strike price of $55/share and your loss is now limited since if XYZ increased to $100 and your loss on the short position is huge, it is offset by the increase in value of your call option (which became In-The-Money when XYZ started trading above $55/share).

This is known as a “protected short sale” or a “synthetic put”. It is essentially the same thing as just buying a put in the first place – since owning a $50 put on XYZ would be profitable if XYZ fell below $50, but your loss is limited (to what you paid for the put in this case).

If you want to learn more about options, make sure to check out Mark Wolfinger’s blog.

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