Most investors focus their attention on finding stocks that will go up in value. However, it’s just as possible to make money from stocks whose values are declining. In order to profit from this circumstance, investors perform what’s called “shorting” stock. Shorting a stock means to sell shares which an investor doesn’t own, but has temporarily borrowed.

The investor’s hope is to borrow the shares of stock, sell them at a high price, wait for the price to fall, buy them back at the lower price, return the borrowed shares to their original owner, and pocket the profit. The profit, in this case, is the difference in price between when the investor “sold high” and then “bought low”.

Let’s take a look at an example. Investor Q believes that ABC, Inc.’s common stock, which is selling at $60 per share, is overvalued. He therefore borrows one thousand shares of ABC from another investor who owns the stock. Q then sells the borrowed shares for $60 each. The borrowing of the shares is usually facilitated by the brokerage firm that the investor uses to execute the short sale.

After selling the stock, its value falls to $40 per share. At this point Q repurchases the thousand shares, returns them to their original owner, and retains a profit of $20 per share, less the expenses of margin interest and transaction fees.

Shorting stock must always be done in a margin account in order to protect the party who lends the shares. A margin account is a brokerage account in which the broker lends the account holder cash with which to buy securities. Because of investing with the use of leveraged money, possible gains and losses are substantially increased. In our example above, because investor Q is shorting one thousand shares of a $60 stock, he would have to deposit $30,000 into a margin account (fifty percent of the value of the shorted stock). When the shares are actually sold, the proceeds of $60,000 would bring the margin account’s balance up to $90,000. This serves as collateral for the short sale by insuring that the party who shorts the stock, in this instance Q, has the funds available and ready to repurchase the shares so that they can be returned to their original owner.

In a short sale, the investor loses if the price of the stock rises instead of falls. Going back to investor Q, if after he had sold the shares their price rose to $75, he would have suffered a loss of $15 per share (in this instance $15,000). Because there’s no limit to how high the value of a stock can rise, shorting a stock is considered to be riskier than buying a stock. The most that an investor can lose by buying a stock is 100% of his or her investment (for instance, if the stock’s value becomes completely worthless). However, if an investor shorts a stock and its value suddenly skyrockets, the loss suffered can be substantially more than the investor’s original 100%.

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