Page 142

your account. Now remember that you have borrowed these shares to short so the $1,000 proceeds is sort of like a loan and you would need to pay interest on it as long as your account is short these 20 shares. For simplicity let’s omit the interest calculations. If your forecast turns out to be correct and Ford stock plummets to $25 per share, you can settle your short position by buying 20 shares of Ford at this lower price by placing an order known as buy to cover. In effect you are now buying shares to cover or settle your short position. So from the $1,000 original proceeds, you spend $500 to buy the 20 shares of Ford at $25 per share. You short position is now settled and the remaining $500 is yours to keep. Pretty good, huh?

I am sure you are now thinking, what happens if Ford stock increases in price? As you may guess this is bad news. Since you are short 20 shares of Ford, you would have to cover this at some point. As the stock price moves up, it becomes more and more expensive to cover your short position. At $100 per share, you must pay $2,000 to buy 20 shares of Ford and cover your position. That puts you $1,000 in a hole. And there is the pitfall I was talking about. When you buy a certain stock, no matter how far the stock price drops, your potential loss is limited to the original amount you have spent. So for example, if you bought 20 shares of Ford for $50 per share for a total of $1,000 and hypothetically Ford stock goes to $0, your loss would be $1,000. But when you short a stock, your potential loss is theoretically unlimited, as the stock price could move higher and higher making it more and more expensive for you to cover the short position. For example, if you had shorted 20 shares of Ford at $50 per shares and the stock rises to $5,000 per share, you would need $100,000 to buy the 20 shares and cover your short position. You get the idea.

This scenario, while possible, is unlikely. Your broker would make sure that you always have enough cash or equity around to cover your …