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.

RELATED FAQS
  1. How does somebody make money short selling?

    Short selling is a fairly simple concept: you borrow a stock, sell the stock and then buy the stock back to return it to ... Read Answer >>
  2. Please explain what a short seller is on the hook for when he or she shorts a stock ...

    Short selling is hard enough to get your head around without getting into all the particulars. If you have a basic understanding ... Read Answer >>
  3. How long can you short sell for?

    When an investor or trader enters a short position, he or she does so with the intention of profiting from falling prices. ... Read Answer >>
  4. Can a stock lose all its value? How would this affect a long or short position?

    The answer to the first part of this question is pretty straightforward: yes, stocks are able to lose all their value in ... Read Answer >>
  5. Are IPOs available to short sell immediately upon trading, or is there a time limit ...

    The quick answer to this question is that an IPO can be shorted upon initial trading, but it is not an easy thing to do at ... Read Answer >>
Related Articles
  1. Investing

    Short Sell Your Home to Avoid Foreclosure

    Are you in danger of losing your home? Protect your credit score with a real estate short sale.
  2. Trading

    Short Sales For Market Downturns

    This strategy can help in market downturns, but it's not for inexperienced traders.
  3. Investing

    The Basics Of Short Selling

    Short sellers enable the markets to function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
  4. Investing

    Using Short ETFs to Battle a Down Market

    Instead of selling your stocks to get gains, consider a short selling strategy, specifically one that uses short ETFs that help manage the risk.
  5. Investing

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  6. Trading

    The Stop-Loss Order - Make Sure You Use It

    It's a simple but powerful tool to help you implement your stock-investment strategy. Find out how.
RELATED TERMS
  1. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  2. Short Covering

    Buying back borrowed securities in order to close an open short ...
  3. Short Sell Against the Box

    The act of short selling securities that you already own. This ...
  4. Short Market Value

    The market value of securities sold short through an individual's ...
  5. Cushion Theory

    The theory used when many investors have taken a short position ...
  6. Short Interest Ratio

    A sentiment indicator that is derived by dividing the short interest ...
Hot Definitions
  1. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  2. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  3. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
  4. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities ...
  5. Wash-Sale Rule

    An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security ...
  6. Porter Diamond

    A model that attempts to explain the competitive advantage some nations or groups have due to certain factors available to ...
Trading Center