If I short sell $5,000 worth of stock and the stock becomes worthless, I have made $5,000 with a very small investment. Isn't the return here much greater than 100%?

By Chad Langager AAA
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.

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