What it means
In most investments, the worst outcome is losing the money you put in. If you buy a share for $50, the price cannot fall below zero, so your loss is limited to $50.
Unlimited risk breaks this rule because the loss can keep growing as long as the market moves against you. Short selling is the classic example.
A short seller borrows shares and sells them, hoping to buy them back later at a lower price, but if the price rises there is no upper limit on how high it can go. Selling a call option without owning the underlying shares, known as writing a naked call, has the same feature.
Unlimited risk also exists in business structures. A sole trader or a partner in a general partnership is personally responsible for the business's debts, so creditors can pursue private assets such as savings and property.
By contrast, shareholders in a limited company generally risk only what they invested, which is why that structure exists. Risk managers deal with it by setting limits and using protective tools.
Stop-loss orders can close a position at a set price, margin requirements force traders to deposit security as losses grow, and hedging with other positions can cap the exposure. Insurance and limited liability structures are also used to turn unlimited exposure into a defined one.
A useful comparison is with unlimited gain. A bought share has unlimited upside and limited downside, while a short position has limited upside, since the price cannot fall below zero, and unlimited downside.
Many professionals treat unlimited-risk positions as suitable only for those with strong risk controls and a high capacity to absorb losses. Margin accounts add a practical layer to the problem.
When a short position moves against the trader, the broker demands more collateral, and failure to provide it can force the position to be closed at the worst moment. This forced closing can push prices up further when many traders are caught at once, a pattern known as a short squeeze.
In practice
Real-world examples.
Example
A hedge fund sells shares it does not own, expecting a company's results to disappoint. Instead the company announces a takeover, the price doubles and the fund must buy back at a heavy loss.
Example
A sole trader running a building firm takes on a large contract and cannot complete it. His creditors can claim his personal savings and home, because there is no legal separation between him and the business.
Example
A trader writes naked call options on a share priced at $40. If the share jumps to $90, she must deliver shares worth much more than the premium she collected, and the loss keeps rising with the price.
Formula
Calculation
Loss on a short position = (buy-back price - sale price) x number of shares
A trader short sells 1,000 shares at $50, receiving 1,000 x 50 = $50,000. The price rises to $120, and she buys the shares back at 1,000 x 120 = $120,000. Her loss is 120,000 - 50,000 = $70,000, which is more than the $50,000 sale proceeds. If the price had risen to $200, the loss would have been 1,000 x (200 - 50) = $150,000.Case study
Seen in the real world.
Birchwell Trading is an illustrative, fictional small firm whose owner sold uncovered call options on a technology share to earn regular premium income. For two years it collected about $5,000 a month with no problems.
When the share price jumped 80% in a week after unexpected news, the firm faced losses of more than $400,000, against a total trading account of $150,000. Its broker issued margin calls, which are demands for more money to cover the losses, and the owner had to sell personal assets to meet them.
Afterwards the firm switched to covered positions and set a rule that no single trade could risk more than 2% of the account. The illustrative lesson is that a long run of small gains can hide a risk with no ceiling. The owner also arranged a standing review with her broker each quarter, so that every open position and its worst-case loss were written down.
Watch out
Common mistakes.
- Assuming the maximum loss is the amount invested, which is true for a bought share but not for a short sale or a naked option.
- Believing that a stop-loss order guarantees a limit, when a fast market can cause the order to execute at a much worse price.
- Overlooking personal liability in a sole trader or general partnership, where private assets can be used to meet business debts.
Questions
People also ask.
Which investments have unlimited risk?
Examples include short selling, writing uncovered call options, and some futures positions, where losses can exceed the initial deposit.
How can unlimited risk be reduced?
You can hedge with other positions, buy protection such as options, use position limits and stop orders, or choose a limited liability structure.
Is unlimited risk always bad?
Not always, since some professionals use such positions with strict controls, but it demands more capital and discipline than limited-risk strategies.
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