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.

RELATED FAQS
  1. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  2. How does a broker decide which customers are eligible to open a margin account?

    Brokers have the sole discretion to determine which customers may open margin accounts with them, although there are regulations ... Read Full Answer >>
  3. Are there leveraged ETFs that follow the retail sector?

    There are many exchange-traded funds (ETFs) that track the retail sector or elements of the retail sector, and some of those ... Read Full Answer >>
  4. What is the interest rate offered on a typical margin account?

    Interest rates on margin accounts vary according to the size of the loan and the brokerage firm being used. Generally, interest ... Read Full Answer >>
  5. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
  6. What are some common cash-debt strategies that occur during a spinoff?

    Cash-debt strategies that are commonly used to in a spinoff to enable the parent company to monetize the spinoff are debt/equity ... Read Full Answer >>
Related Articles
  1. Investing Basics

    What Happens in a Haircut?

    One meaning of haircut is the difference between prices at which a market maker can buy and sell a security.
  2. Mutual Funds & ETFs

    ETF Analysis: Direxion Daily Financial Bull 3X

    Obtain a thorough review and analysis of the Direxion Daily Financial Bull 3X fund, a leveraged ETF that tracks the performance of the financial sector.
  3. Investing Basics

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  4. Markets

    The Origins of the Chinese Stock Market Collapse

    Learn about some of the reasons for the volatility in the Chinese stock market, including expansion of margin lending and governmental support.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Stock Analysis

    Investors Need to Stop Shorting GoPro. Here's Why

    Discover why investors should stop shorting GoPro. GoPro has been one of the fastest-growing companies since 2005 with many betting against more growth.
  7. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
  8. Stock Analysis

    3 Reasons to Short Monster Beverage

    Learn why, despite the popular perception of Monster Beverage as a high-growth stock, investors may be better off taking a short position on it.
  9. Stock Analysis

    How Rollins Inc. Transformed from Radio to Pest Control

    Discover how Rollins, Inc. grew and expanded, making numerous acquisitions, transitioning from the radio industry to the pest control industry.
  10. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Debt/Equity Ratio

    1. A debt ratio used to measure a company's financial leverage. ...
  3. Marginable

    Definition of "marginable."
  4. Bear Closing

    Purchasing a security, currency, or commodity in order to close ...
  5. Borrowing Power Of Securities

    The value associated with being able to invest in securities ...
  6. Crowded Short

    A trade on the short side with an overwhelmingly large number ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!