Shorting a stock means selling shares you don't own on the hope of making money when a stock price falls. While shorting allows a knowledgeable investor to make money even when stocks depreciate, it is more complex and risky than a straightforward share purchase.
Shorting Basics
If a stock currently trades at $52 per share and you believe the price has peaked, you may want to short it to profit when the price falls. To do so, you actually borrow shares from your brokerage and sell them. When the price falls to a desired point or rises to the point of your loss threshold, you "buy to cover" the borrowed shares. If the $52 stock drops to $35 before you buy to cover, you earn $17 per share. If you buy to cover at $54, you lose $2 per share even though the price appreciated.
Margin Requirements
When you short-sell, you incur a liability with the broker from whom you borrow shares. Because of this, a short seller is required to hold a margin account with the brokerage. A margin account means a borrower maintains a certain balance in the account and then has access to additional funds for trading via credit. On a 50 percent margin account, for example, you would need $25,000 in the account to have access to another $25,000 in borrowed funds.
Short Sale Market Risks
You face significant risks as a short seller. When you buy a stock in the traditional manner, you risk losing only the value you invest. When you short, your potential losses are unlimited as the stock price continues to climb. Shorting a stock at $3 leads to huge losses if you buy to cover at $10. Brokerages may also issue a "margin call" when the stock price rises, which means you must add more funds to cover the margin differential. Brokers may also take liberties in restricting short sale concentrations in one stock.
Additional Short Sale Risks
Short sellers face other risks beyond conventional market movement. When you short a stock on a dividend execution date, you must actually pay the dividend amount per share. In contrast, "owners" of a stock receive dividend income on shares. Another risk is that a company whose stock is at the center of your short sale will split into two public companies. If the stocks both lose value, your losses grow more quickly.