A:

Money can be made in the equities markets without actually owning any shares, but this tactic is not for new investors. The concept of short selling involves borrowing stock you do not own, selling the borrowed stock and then buying and returning the stock when the price drops. It may seem intuitively impossible to make money this way, but short selling does work. However, it is worth noting that in short selling, the losses may be unlimited, while the gains are not.

The short selling process works like this: An investors opens up a margin account with a broker, usually with an initial investment of $10,000. Short selling accounts require a type of security deposit, called a maintenance margin. The margin is required to ensure that the shorted stock can be returned to the borrower. After an account is set up, the investor is ready to short stock in the market. (For more insight, see What are the minimum margin requirements for a short sale account?)

The object, as was stated earlier, is to sell the stock and then buy it back at a lower price than what the price was initially. Any profit that the investor makes is on the difference between those two prices. For example, assume that Joe the investor believes FGH Corp.'s stock is going fall in price. The current market price is $35 per share. Joe takes a short position on FGH and borrows 1,000 shares of the stock at the current market rate. Five weeks later, FGH falls to $25 per share, and Joe decides to purchase the stock, which is called buying to cover. Joe's profits are going to be $10,000 [($35 - $25) x 1,000], less any brokerage fees associated with the short position.

Short selling is risky because stock prices, historically speaking, increase over time; theoretically, there is no limit to the amount a stock price can rise, and the more the stock price rises, the more will be lost on a short. For example, assume Joe the investor makes the same short at $35, but instead the stock increases to about $45. Joe, if he covered at this price, would lose $10,000 [($25 - $35) x 1,000] plus any fees, but there may be nothing stopping FGH's stock price from increasing to $100 per share or even higher!

While the downside of a short is unlimited, the plus side has a calculable limit. Assume that Joe takes the same short with the same stock and price. After a few weeks, FGH falls to $0 per share. The profit from the short would be $35,000 less fees. Here, this gain represents the maximum that Joe can make from this investment.

For further reading, see How does somebody make money short selling? and the Short Selling tutorial.

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