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.

  1. Under what circumstances is short selling advisable?

    Find out when short selling a stock is profitable and what an investor should keep in mind before deciding to pursue a short ... Read Answer >>
  2. 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 >>
  3. 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 >>
  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 a trader keep a short position?

    Learn whether there are any limitations on how long may an investor hold a short position, and explore the costs associated ... Read Answer >>
  6. When short selling, how long should you hold on to a short?

    Explore the reasons for short selling and the various factors that influence how long an investor may wish to maintain a ... Read Answer >>
Related Articles
  1. Financial Advisor

    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

    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.
  3. Trading

    Guide to Short Selling

    Want to profit on declining stocks? This trading strategy does just that.
  4. Investing

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  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

    Short Sales For Market Downturns

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

    Short Interest: What It Tells Us

    This figure can be a real eye-opener about the market sentiment surrounding a given stock.
  1. Buy To Cover

    A buy order made on a stock or other listed security that closes ...
  2. Short Covering

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

    Short selling is the sale of a security that is not owned by ...
  4. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  5. Short (or Short Position)

    A short position is the sale of a borrowed security, commodity ...
  6. Short Interest Ratio

    A sentiment indicator that is derived by dividing the short interest ...
Hot Definitions
  1. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  2. Federal Debt

    The total amount of money that the United States federal government owes to creditors. The government's creditors include ...
  3. Passive Management

    A style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. ...
  4. Series 7

    A general securities registered representative license administered by the Financial Industry Regulatory Authority (FINRA) ...
  5. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  6. Expatriation Tax

    An expatriation tax is a tax on someone who renounces their citizenship. In the United States, the expatriation tax provisions ...
Trading Center