A:

The simple answer to this question is that there is no limit to the amount of money you can lose in a short sale. This means that you can lose more than the original amount you received at the beginning of the short sale. Therefore, it is crucial for any investor who is using short sales to monitor his/her positions and use tools such as stop-loss orders. (To learn more, see The Stop-Loss Order - Make Sure You Use It.)

First, you need to understand the short sale itself. When you short a stock, you are hoping the stock's price will fall as far as possible. Because stocks never trade in negative numbers, the furthest a stock can possibly fall is to zero. This puts a limit on the maximum profit that can be achieved in a short sale. On the other hand, there is no limit to how high the price of the stock can rise, and because you are required to return the borrowed shares eventually, your losses are potentially limitless. This is why you are able to lose more money than you received from the investment in the short. (For further information, see our Short Selling Tutorial.)

For example, if you were to short 100 shares at $50, the total amount you would receive would be $5,000. You would then owe the lender 100 shares at some point in the future. If the stock's price dropped to $0, you would owe the lender nothing and your profit would be $5,000 or 100%. If, however, the stock price went up to $200 per share, when you closed the position you would return 100 shares at a cost of $20,000. This is equal to a $15,000 loss or -300% return on the investment ($5,000 - $20,000 or -$15,000/$5,000).

The loss created by a short sale gone bad is like any other debt. If you are unable to pay for this debt, you will have to sell other assets to pay for the debt, or file for bankruptcy. The good news is that you are unlikely to sustain such massive losses. When you open a margin account, you usually sign an agreement stating that the brokerage firm can institute stops which essentially purchase the shares on the market for the investor and close the position. This purchase returns the shares to the lender, and the purchase amount is owed by the short investor to the firm. So, while the mechanics of a short sale mean the potential for infinite losses is there, the likelihood of you actually experiencing infinite losses is small.

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