How hedge funds manage risk when shorting stock and commodities

Short selling is, by its very nature, a high-risk, high-reward investment technique. While the returns on a short sell can be lucrative when successful, the losses can, in theory, be limitless and any surge in price movements can have a devastating effect on investors with a short position and it's crucial to understand the benefits and risks of short-selling stocks for hedge fund managers.

Naturally, hedge funds will always commit to thorough research and analysis before opening a short position on a stock or commodity, but not all price changes can be planned for. For example, a short squeeze on a heavily shorted stock will likely push its share price up, as would any unexpected developments or announcements that could have a positive effect on the stock’s future performance.

Despite the high stakes of shorting stocks and the volatility of commodities, there are still many hedge funds that centre their entire investment strategy on short selling. But how do they manage the associated risks?

Managing risk when short stocks and commodities

Entry and exit points

The ability to maintain objectivity when investing is a crucial trait that can influence a hedge fund’s overall success on the market. This is just as important, if not more important, when it comes to short selling, as the success of a single trade can rely heavily on timing. In fact, figuring out the best time to open and close a short position and actually sticking to those predetermined entry and exit points is a key factor in reducing the risk of short selling.

Hedge funds will often use stop-loss orders to aid their timekeeping when trading. These special order types automatically execute the buying or selling of a stock or security when its share price reaches a certain value.

With that in mind, a hedge fund opening a short position would use a stop-loss order to ensure that the share price of its shorted stock or commodity doesn’t rise above a certain level. If it does, a buy order would be executed and the hedge fund will have bought the stock for a predetermined price, thus limiting the loss of the short position.

Without a stop-loss order in place, the losses of an unsuccessful short could potentially be limitless.

Using options to hedge

By using options, institutional investors are able to hedge their short positions against risk and effectively limit any losses that may occur if the price of their shorted stock or commodity rises, contrary to their expectations.

The process is fairly simple, as the hedge fund only needs to take out a call option on the stock it wants to short, at the same time it opens a short position. By doing this, the hedge fund will have given itself the option to buy the stock at a certain price within a set time limit.

This works to offset the risk of a loss because the hedge fund will eventually have to give back the shares it borrowed to open the short position, regardless of the price movement. So, by having a call option in place, the hedge fund is able to limit how much it would have to pay to buy the shares when it comes to closing its short position.

It’s worth keeping in mind that this strategy will only work with stocks and commodities for which options are available, and investors will do well to check before committing to painstaking research of a stock they intend to short and buy a call option on - here we look more at how hedge fund managers can find short selling stocks.

Assuming that this strategy can be followed, investors should also remember that there is a limit on how long a call option can protect a short position as all calls eventually expire. Furthermore, the cost of a call option that has a longer expiration date will be more expensive.

While this is a somewhat more complicated strategy than using stop-loss orders, it can be more effective, particularly for successful investors. A call option can even bolster the profit made on a successful short – provided the circumstances work out in their favour.

For instance, if a hedge fund has a short and a call already in place and the asset price drops sooner than expected, then the hedge fund can close its short position early and make a profit. If the value then rebounds, the hedge fund will be able to profit on the call option as well. Although these kinds of occurrences are rare, they are by no means impossible.

Despite all of these risk mitigation strategies, the best way to avoid making considerable losses on a short sell is to thoroughly research, assess and analyse a stock, commodity or security before opening a short position. Hedge funds should also consider the wider sector of the stock and the market as a whole.