Unfortunately, it is easy to lose more money than you invest when you are shorting a stock, or any other security, for that matter. In fact, there is no limit to the amount of money you can lose in a short sale (in theory).
key takeaways
- You can lose more than you invest in a short sale if the stock you borrowed for the deal rises in price, instead of falling as you assumed it would.
- While theoretically, you could lose an unlimited amount, in actuality losses are usually curtailed: The brokerage institutes a stop order, which essentially purchases the shares on the market for you, closing out your position and your exposure to further price increases.
Short Selling Basics
First, it's important to understand the short sale itself. A short sale is a transaction in which the seller does not actually own the stock that is being sold but borrows it (or the money to buy it) from a broker-dealer, the one through which the sell order is placed. The seller then has the obligation to buy back the stock at some point in the future. Short sales are margin transactions: You are putting up just a portion of your own cash and getting a loan for the rest of the deal.
When you short a stock, you are hoping the stock's price will fall as far as possible. Because stocks never trade in negative numbers, the furthest a stock can possibly fall is to zero. This puts a limit on the maximum profit that can be achieved in a short sale. On the other hand, there is no limit to how high the price of the stock can rise, and because you are required to return the borrowed shares eventually, your losses are potentially limitless. This is why you are able to lose more money than you received from the investment in the short.
Example of a Short Sale Loss
For example, if you were to short 100 shares at $50, the total amount you would receive would be $5,000. You would then owe the lender 100 shares at some point in the future. If the stock's price dropped to $0, you would owe the lender nothing and your profit would be $5,000, or 100%. If, however, the stock price went up to $200 per share, when you closed the position you would return 100 shares at a cost of $20,000. This is equal to a $15,000 loss, or -300% return on the investment ($5,000 - $20,000 or -$15,000 / $5,000).
Consequences of a Short Sale Loss
The loss created by a short sale-gone-bad is like any other debt. If you are unable to directly pay what you owe, you will have to sell other assets to cover itor—worst-case scenario—file for bankruptcy.
The good news is that you are unlikely to sustain such massive losses. When you open a margin account, you usually sign an agreement stating that the brokerage firm can institute stop orders, aka "stops," if the security starts moving significantly against you. In this case, it'd specifically be a buy-stop order, which essentially purchases the shares on the market for the investor and closes the position. This transaction returns the shares to the lender, and the purchase amount is owed by the short investor to the firm; you may still lose money, but the danger of the stock going sky-high and wiping you out is curtailed. So, while the mechanics of a short sale mean the potential for infinite losses is there, the likelihood of you actually experiencing infinite losses is small.
The Bottom Line
It is crucial for any investor who is using short sales to monitor their positions and use tools such as stop-loss orders or other various stop-limit strategies.
