A:

The simple answer is that the maximum return of any short sale investment is in fact 100%. However, the concepts underlying short selling - the borrowing of shares and the liability it forms, how returns are calculated, etc. - can be anything but simple. Let's try to clear up the confusion.

To calculate the return on a short sale, all you need to do is calculate the difference between the proceeds from the sale and the cost to close the position. This value is then divided by the initial proceeds from the sale of the borrowed shares. If you were to short 100 shares at $50 a share, the total proceeds of the sale would be $5,000 ($50*100) and that amount would be deposited in the shorts account. If the stock fell to $30 and you closed your position, it would cost you $3,000 ($30*100), which would leave you with $2,000 in your account ($5,000-$3,000). The return that is calculated would be $2,000 divided by the initial proceeds from the sale of the borrowed shares and would be equal to a 40% return.

If the borrowed shares dropped to $0 in value, you would not have to repay anything to the lender of the security and your return would be 100%. The reason why this calculation causes confusion is that no out of pocket money is put into the stock at the start of the trade. To many, it seems that when you can make $5,000 without spending a dollar of your own money, the return is well over 100%. This, however, is not the case.

returnshort21.gif

This chart helps to clarify how different returns are calculated, based on the change in the price of the stock and the amount that is owed to cover the liability.

The reason why short sales are limited to a return of 100% is that they create a liability the moment they are instituted. While the liability does not translate into an investment of real money by the short seller, it is essentially the same thing as investing the money: it is a liability that needs to be paid back in the future. The short seller is hoping that this liability will disappear, and for this to happen the shares would need to go to zero. This is why the maximum gain on a short sale is 100%. The maximum amount the short seller could ever take home is the proceeds from the short sale - in the case of our example, $5,000 (the same amount as the initial liability). When calculating the return of a short sale, you need to compare the amount the trader gets to keep to the initial amount of the liability. Had the trade in our example turned against you, you (as the short seller) would owe not only the initial proceeds amount but also the excess amount, and this would come out of your pocket.

To learn more, see our Short Selling Tutorial.

RELATED FAQS
  1. What are the minimum margin requirements for a short sale account?

    In a short sale transaction, the investor borrows shares and sells them on the market in the hope that the share price will ... Read Answer >>
  2. What percentage of a company's float can be shorted?

    The quick answer is that the amount of shares shorted can actually exceed 50% of the float in a company. The percentage of ... Read Answer >>
  3. Please explain what a short seller is on the hook for when he or she shorts a stock ...

    Short selling is hard enough to get your head around without getting into all the particulars. If you have a basic understanding ... Read Answer >>
  4. How does somebody make money short selling?

    Short selling is a fairly simple concept: you borrow a stock, sell the stock and then buy the stock back to return it to ... Read Answer >>
  5. When short selling, how long should you hold on to a short?

    Explore the reasons for short selling and the various factors that influence how long an investor may wish to maintain a ... Read Answer >>
  6. What is the difference between a short squeeze and short covering?

    Learn about short covering and short squeezes, the difference them and what causes short squeezes. Read Answer >>
Related Articles
  1. Investing

    The Basics Of Short Selling

    Short sellers enable the markets to function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
  2. Investing

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  3. Trading

    Short Sales For Market Downturns

    This strategy can help in market downturns, but it's not for inexperienced traders.
  4. Trading

    Short Interest: What It Tells Us

    This figure can be a real eye-opener about the market sentiment surrounding a given stock.
  5. Investing

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  6. Trading

    The Short Squeeze Method

    The short squeezed strategy can be risky - but also very rewarding - for those who master it.
  7. Financial Advisor

    The 5 Most Shorted NYSE Stocks (VALE, CHK)

    Understand what a short sale is and why people would want to initiate a short strategy. Learn about the top five most shorted stocks on the NYSE.
  8. Investing

    The Truth About Naked Short Selling

    The media demonizes naked short selling, but in most cases it occurs in a collapse, rather than causing it.
RELATED TERMS
  1. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  2. Short Selling

    Short selling is the sale of a security that is not owned by ...
  3. Short Market Value

    The market value of securities sold short through an individual's ...
  4. Short Interest Ratio

    A sentiment indicator that is derived by dividing the short interest ...
  5. Days To Cover

    A measurement of a company's issued shares that are currently ...
  6. Rebate

    1. In a short-sale transaction, the portion of interest or dividends ...
Hot Definitions
  1. Block (Bitcoin Block)

    Blocks are files where data pertaining to the Bitcoin network is permanently recorded.
  2. Fintech

    Fintech is a portmanteau of financial technology that describes an emerging financial services sector in the 21st century.
  3. Ex-Dividend

    A classification of trading shares when a declared dividend belongs to the seller rather than the buyer. A stock will be ...
  4. Debt Security

    Any debt instrument that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount ...
  5. Taxable Income

    Taxable income is described as gross income or adjusted gross income minus any deductions, exemptions or other adjustments ...
  6. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly AIMR) that measures the competence and integrity of financial ...
Trading Center