Calculating the Return on Short Sales

What's the return if I short sell $5,000 worth of stock that becomes worthless?

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

Key Takeaways

  • To calculate the return on a short sale, first determine the difference between the sale proceeds and the cost associated with selling off the position.
  • Next, divide this value by the initial proceeds from the sale of the borrowed shares.
  • The investor does not have to repay anything to the lender of the security if the borrowed shares drop to $0 in value.
  • If the borrowed shares drop to $0 in value, the return would be 100%, which is the maximum return of any short sale investment.

How to Calculate a Short Sale Return

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

Consider the following hypothetical trade. Let us assume that an investor shorts 100 shares of a stock at $50 per share. In this scenario, the total proceeds of the sale would be $5,000 ($50x100). This amount would be deposited into the associated brokerage account. If the stock fell to $30 and the investor closed the position, it would cost them $3,000 ($30x100), thereby leaving $2,000 in the account ($5,000 - $3,000). Consequently, the return would equal 40%, which is calculated by dividing the $2,000 left in the account by the initial proceeds from the sale of the borrowed shares ($5,000).

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

The goal of short-sellers is to make money by borrowing shares of stock (usually from a broker-dealer) and then profiting from the use of those shares before returning them to the lender.

Examples of Returns on Short Sales

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

  Shares Share Price Sales Proceeds Owed Percent 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 50%
Shares lose 75% 100 $12.50 $5,000 $1,250 75%
Shares lose 99% 100 $0.50 $5,000 $50 99%
Shares lose 100% 100 $0.00 $5,000 $0 100%
Shares gain 50% 100 $75 $5,000 $7,500 -50%
Shares gain 100% 100 $100 $5,000 $10,000 -100%
Shares gain 200% 100 $150 $5,000 $15,000 -200%

Short sales are limited to a 100% return because they create a liability the very first moment they are executed. Although the liability does not translate into an investment of real money by the short seller, it is equivalent to investing the money in that it's a liability that must be paid back at a future date.

The short seller hopes that this liability will vanish, which can only happen if the share price drops to zero. That is why the maximum gain on a short sale is 100%. The maximum amount the short seller could ever take home is essentially the proceeds from the short sale. In the aforementioned example, that figure would be $5,000, which represents the same amount as the initial liability.

The Bottom Line

When calculating the return of a short sale, one must compare the amount that the trader is entitled to keep, with the initial amount of the liability. Had the trade in our example turned against the short seller, they would not only owe the amount of the initial proceeds, 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 borrowing transaction, which must be done in a margin account. The variables for those additional costs should be discussed before entering into this type of transaction.

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