What it means
The term describes an idea that looks easy but hides a severe downside. A classic case is shorting a stock that looks overpriced, which means borrowing shares and selling them in the hope of buying them back cheaper.
If the price keeps rising instead, the losses have no upper limit, because a share price can rise without a ceiling but can only fall to zero. In commodity markets, the phrase is linked to certain futures spreads.
The best-known is the natural gas spread between March and April contracts, which has had violent moves when winter supply ran short. Traders use the label to warn each other that a spread which looks like a safe bet can suddenly move against them by a large amount.
The common thread is a poor trade-off between a small expected gain and a large possible loss. Positions that rely on borrowed money are particularly dangerous, because leverage (using borrowed funds to increase the size of a position) magnifies losses as well as gains.
A margin call, which is a demand to deposit more cash, can force a trader to close out at the worst moment. For businesses, the same thinking applies outside the trading floor.
A company that sells unlimited insurance-like promises, or that hedges a risk with an instrument whose loss is unbounded, is running its own widow maker. Finance teams guard against this with position limits, stop-loss rules and a requirement to ask what the worst realistic outcome could be.
The term is slang and has no precise technical definition, so it should not be used in formal reports without explanation. In some other fields the same name refers to physical dangers, for example a hanging branch in forestry, so context matters.
In markets, it is always a warning about hidden tail risk.
In practice
Real-world examples.
Example
A hedge fund shorts a heavily indebted retailer that it believes is heading for bankruptcy. A takeover rumour sparks a sharp rally, and the fund must buy back shares at much higher prices, losing several times what it expected to gain.
Example
A commodity trader builds a large winter gas spread position with borrowed money, expecting prices to behave as in previous years. A cold snap spikes the price, margin calls arrive within hours and the trader's firm closes the position at a heavy loss.
Example
A small business owner sells a customer an uncapped price guarantee on a metal that the business buys at market prices. When the metal price surges, the business must honour the guarantee and sells below cost on every order.
Formula
Calculation
Loss on a short position = (Buy-back price - Sale price) x Number of shares
Maximum gain on a short position = Sale price x Number of shares
Suppose a trader shorts 1,000 shares at $20, expecting a fall. The best possible outcome is the shares falling to $0, a gain of 20 x 1,000 = $20,000. If the price instead jumps to $80, the loss is (80 - 20) x 1,000 = $60,000, which is three times the maximum possible gain. If it reached $150, the loss would be (150 - 20) x 1,000 = $130,000.Case study
Seen in the real world.
Copperfield Capital is a fictional trading firm used here as an illustrative example. One of its traders took a large short position in a small manufacturing company, believing that the shares were worth $12 against a market price of $20. The position was $2,000,000 in size, financed partly on margin.
A surprise acquisition offer sent the share price to $32 within a week, and Copperfield's loss on the position reached $1,200,000. The risk committee later introduced a rule that no single short position could risk more than 2% of the firm's capital, with a mandatory exit if the price rose 25% above entry. The illustrative lesson is that a trade with unlimited downside needs a fixed exit before it is opened.
Watch out
Common mistakes.
- Focusing only on the potential gain and ignoring the size of the worst-case loss.
- Using borrowed money on a position whose loss is not capped, which can turn a bad day into a business-ending one.
- Believing that a trade is safe because it has behaved well in past years, when rare spikes are exactly what make a widow maker dangerous.
Questions
People also ask.
Is every short sale a widow maker?
No, a short sale becomes a widow maker when it is large, leveraged and has no exit rule, whereas a small, well-controlled short can be a normal tool.
How can a trader limit the risk?
Common tools include stop-loss orders, strict position size limits and buying options that cap the maximum loss.
Why are natural gas spreads linked to the name?
Winter weather can cause sudden jumps in the near-term contract while later contracts barely move, which can punish traders who expected a calm spread.
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