Money can be made in the equities markets without actually owning any shares of stock.
Short selling involves borrowing stock you do not own, selling the borrowed stock, and then buying and returning the stock only if and when the price drops. It may seem intuitively impossible to make money this way, but short selling does work. That said, it is not a strategy recommended for first-time or new investors.
Because of the risky nature of short selling, certain protections have been put into place.
First, shorting can only be done with a margin account, which needs to be set up by a broker. While the rules and regulations of margin accounts vary, all require an initial minimum equity commitment—usually $5,000. But that's just for opening an account. If there's a stock you want to short, you must have 100% of the short sale proceeds, plus another 50% of the short sale value in your margin account.
For example, if you sold short 100 shares of XYZ stock at $20, you would need to have the full value of that sale, $2,000, plus an additional $1,000, in your margin account at the time.
Additionally, the Financial Industry Regulatory Authority (FINRA) requires that you keep at least 25% of the total value of the equities in your account as a maintenance margin at all times. Many brokerage firms require an even higher percentage to protect themselves and you, their client, from potentially devastating losses.
Short Selling and Bold Borrowing
To recap, the object of short selling is to sell a stock and then buy it back at a lower price. Any profit an investor makes is on the difference between those two prices.
Let's say Joe Investor believes XYZ's stock—currently selling at $35 a share— is going to drop in price. Joe takes a short position on XYZ and borrows 1,000 shares of the stock at the current market rate. Five weeks later, XYZ stock falls to $25 per share, and Joe decides to purchase the stock. Joe's profits are going to be $10,000 ($35 - $25 x 1,000), less any brokerage fees associated with the short.
Historically speaking, short selling is risky because stock prices 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 takes the same short at $35, but the stock increases to about $45. If Joe covered his short, at this price, he would lose $10,000 ($25 - $35 x 1,000) plus any fees. But imagine how much he would lose if XYZ's stock price went up to $100 per share or even higher.
On the flip side, profits have a calculable limit. Suppose Joe takes the same short with the same stock and price. After a few weeks, XYZ falls to $0 per share. The profit from the short would be $35,000 minus fees. This gain represents the maximum that Joe can make from this investment.
The Bottom Line
Short selling is a sophisticated investing technique best left to experienced investors with well-honed, instinctive market skills and fairly strong risk tolerance. While the losses are limitless, the gains are not.