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. Why do you need a margin account to short sell stocks?

    The reason that margin accounts and only margin accounts can be used to short sell stocks has to do with Regulation T, a ... Read Answer >>
  3. If I short sell $5,000 worth of stock and the stock becomes worthless, I have made ...

    The simple answer is that the maximum return of any short sale investment is in fact 100%. However, the concepts underlying ... Read Answer >>
  4. 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 >>
  5. 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 >>
  6. 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 >>
Related Articles
  1. Markets

    Why You Should Never Short a Stock

    Short selling a stock means you are betting on the stock decreasing in price. Before taking on this investment, you should fully understand the risks
  2. Investing

    Short Selling: What Is Short Selling?

    Investopedia Explains: The fundamentals of short selling and the difference between going long or short on an investment.
  3. Investing

    Short Selling: The Risks

    Now that we've introduced short selling, let's make one thing clear: shorting is risky. Actually, we'll rephrase that. Shorting is very, very risky. It's not unlike running with the bulls in ...
  4. 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.
  5. 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.
  6. 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.
  7. Markets

    Short Sales For Market Downturns

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

    Making The Trade: Understand Order Types

    Buying and selling stock can be a lot like buying or selling a car. Traders should use and understand tools such as market orders, limit orders, day orders, and good-'til-canceled orders to ensure ...
  9. Financial Advisor

    How to Protect Your Portfolio from a Market Crash

    Although market crashes are usually bad news for your portfolio, there are several ways to minimize losses or even profit outright from market movement.
  10. Trading

    Maximizing Your Return in Up or Down Markets

    Learn how to maximize your profit in both up AND down markets by learning how to short sell.
RELATED TERMS
  1. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  2. Short Sell Against the Box

    The act of short selling securities that you already own. This ...
  3. Short Covering

    Buying back borrowed securities in order to close an open short ...
  4. Short Selling

    Short selling is the sale of a security that is not owned by ...
  5. Buy To Cover

    A buy order made on a stock or other listed security that closes ...
  6. Weak Shorts

    Traders or investors who hold a short position in a stock or ...
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center