What happens when you short a stock and its price plummets to zero is the ideal scenario for a short seller, resulting in the maximum possible profit from that position.
Understanding Short Selling Basics
Short selling involves borrowing shares of a stock that you believe will decrease in value, selling them at the current market price, and then repurchasing them later at a lower price to return to the lender. The profit comes from the difference between the higher sale price and the lower repurchase price.
The Ideal Scenario: Stock Goes to Zero
When a shorted stock goes to zero, it means the company's value has completely collapsed, and its shares are essentially worthless. For the short seller, this is the most profitable outcome because the cost to buy back the shares becomes negligible.
Maximizing Your Gains
Consider this practical example:
- Imagine you short-sell 100 shares of a stock at a price of $10 per share.
- Your initial proceeds from this sale would be $1,000 (100 shares x $10/share).
- If the stock's price then drops to $0 per share, you can "buy to cover" those 100 shares for effectively nothing.
- Since you no longer have to spend any money to buy back the shares, you get to keep the full $1,000 from your initial sale as profit, minus any commissions or fees.
This represents the absolute maximum profit you can achieve on a short position, as the stock price cannot go below zero.
Here’s a simplified breakdown:
| Action | Price Per Share | Shares | Total Cash Flow |
|---|---|---|---|
| Short Sell | $10 | 100 | +$1,000 |
| Buy to Cover | $0 | 100 | -$0 |
| Net Profit | $1,000 |
Why This is a Short Seller's Dream
- Maximum Profit Achieved: The entire proceeds from the initial short sale become your profit (less fees).
- Risk Elimination: Once the stock hits zero and you cover your position, the open-ended risk typically associated with short selling (where losses can be unlimited if the stock rises) is eliminated.
- Validation of Thesis: It confirms your original bearish outlook on the company.
Important Considerations for Short Sellers
While a stock going to zero is the best-case scenario for a short seller, it's crucial to remember the inherent risks of short selling:
- Unlimited Loss Potential: Unlike buying a stock (where your maximum loss is your initial investment if it goes to zero), short selling has theoretically unlimited loss potential if the stock price rises significantly. For instance, if the stock in our example had soared to $100 per share, buying back the 100 shares would cost $10,000, resulting in a $9,000 loss.
- Borrowing Costs: You might incur fees for borrowing the shares, and you are responsible for paying any dividends issued by the company during the time you hold the short position. These costs can eat into potential profits.
- Market Dynamics: A stock going to zero often implies severe financial distress, bankruptcy, or delisting of the company. While profitable for the short seller, it highlights significant economic events.
