If I short $ 5,000 worth of stocks and the stocks lose value, wouldn’t the return be much greater than 100%?


The maximum return on any short sale investment is 100%. While this is a simple and straightforward investment principle, the underlying mechanics of short selling, including lending stocks, assessing liability for the sale, and calculating returns, can be thorny and complicated. This article will clarify these issues.

To calculate the return on any short sale, simply determine the difference between the income from the sale and the cost associated with selling that particular position. This value is then divided by the initial proceeds from the sale of the loaned shares.

Consider the following hypothetical trade. Suppose an investor sells 100 shares at $ 50 per share. In this scenario, the total proceeds from the sale would be $ 5,000 ($ 50×100). This amount would be deposited into the associated brokerage account. If the shares fell to $ 30 and the investor closed the position, it would cost them $ 3,000 ($ 30×100), thus leaving $ 2,000 in the account ($ 5,000 – $ 3,000). Consequently, the yield would be equal to 40%, which is calculated by dividing the $ 2,000 remaining in the account by the initial proceeds from the sale of the loaned shares ($ 5,000).

If the borrowed shares fell to $ 0 in value, the investor would not have to repay anything to the title lender and the return would be 100%. Some find this calculation confusing, due to the fact that no pocket money is spent on the shares at the start of the trade. Many investors mistakenly believe that if they can make $ 5,000 without spending a dollar of their own money, the return is well above 100%. This assumption is false.

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The following table clarifies how the different returns are calculated based on the change in share price and the amount owed to cover the liability.

Share Share price Sales revenue Owed Percentage gain
Initial short sale 100 $ 50.00 $ 5,000 $ 5,000 0%
Shares lose 25% 100 $ 37.50 $ 5,000 $ 3,750 25%
Shares lose 50% 100 $ 25.00 $ 5,000 $ 2,500 fifty%
Stocks lose 75% 100 $ 12.50 $ 5,000 $ 1,250 75%
Stocks lose 99% 100 $ 0.50 $ 5,000 $ 50 99%
Stocks lose 100% 100 $ 0.00 $ 5,000 $ 0 100%
Shares earn 50% 100 $ 75 $ 5,000 $ 7,500 -fifty%
Shares earn 100% 100 $ 100 $ 5,000 $ 10,000 -100%
Shares earn 200% 100 $ 150 $ 5,000 $ 15,000 -200%

Short sales are limited to a 100% return because they create a liability from the first moment they are executed. Although the liability does not translate into a real money investment by the short seller, it is equivalent to investing the money in the sense that it is a liability that must be repaid at a future date. The short seller hopes that this liability will disappear, which can only happen if the share price falls to zero. That is why the maximum profit on a short sale is 100%. The maximum amount that the short seller could take home is essentially the proceeds of the short sale. In the example above, that figure would be $ 5,000, which represents the same amount as the initial liability.

When calculating the return on a short sale, the amount the merchant is entitled to keep should be compared to the initial amount of the liability. If the trade in our example had turned against the short seller, they should not only be the amount of the initial revenue, but they would also be on the hook for the excess amount. It should also be remembered that there are often financing costs associated with a short sale, as it is technically a loan transaction, which must be conducted in a margin account. The variables for those additional costs should be discussed before making this type of transaction.

www.investopedia.com

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Mark Holland

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