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. But it is worth noting that in short selling, the losses may be unlimited while the gains are not. (See also: Short Selling.)
Shorting can only be done in a margin account, and is subject to a initial minimum -- usually $5,000 -- equity requirement for using margin. For example, if you sold short 100 shares of XYZ stock at $20, you would need to have half the proceeds of that sale, equivalent to $1,000, in your margin account at that time.
At all times, FINRA requires that you have at least 25 percent of the value of a shorted stock in cash in your account, which is called a maintenance margin.. For example, if you short 100 shares of stock at $20 per share and it goes up to $30, you must have at least $750 in cash in the account, (See also: What Are the Minimum Margin Requirements for a Short Sale Account?)
Short Selling and Bold Borrowing
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 Investor believes XYZ Corp.'s stock is going fall in price. The current market price is $35 per share. Joe takes a short position on XYZ and borrows 1,000 shares of the stock at the current market rate. Five weeks later, XYZ 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 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 XYZ'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, XYZ 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. (See also: How Does Somebody Make Money Short Selling?)