In the stock market, short selling is an inherently risky activity. Much more so than the simple buying of shares. Why? Because when you buy stock in a company, the maximum amount you can lose is the price you paid for the shares. The company’s share price cannot go below zero after all.

However, when you sell short, theoretically the share price could rapidly go from say $15 to $150 or even $1,500. Then, as a short seller, you would be obliged to buy the stock back at the new price and lose a fortune in the process. If you cannot cover those losses, bankruptcy beckons.

The other risk you face with short selling is something known as the “short squeeze”. This is when for example an unexpected piece of good news comes out regarding a company whose stock has been falling, which positively affects that company’s share price. It may be an unexpectedly good earnings report, the announcement of a new product or a major win, or maybe the company is suddenly the target of a takeover bid.

When this happens, there is suddenly a high demand for the stock and any short sellers who were in the market rapidly try to unwind their short positions. With the demand from new investors added to all the short sellers trying to buy their stock back, prices are driven rapidly upwards and as a short seller, you stand to lose a lot of money.

One way to manage the risk of short selling is through the purchase of “out of the money” call options. These are options where the strike price is significantly higher than the current trading price of the stock. You pay a premium to buy these options, which are cheap because there is not much demand to buy a stock at a higher price than it is currently trading in the market. Then, if the share price does suddenly rise, the options become “in the money” (i.e. the strike price is now below the current share price) and you can sell those options for a profit, offsetting your loss on your short position in the underlying stock.

For this reason, it is always wise to hedge any short position in stock with out of the money calls. They act as a sort of insurance policy against unexpected price rises.