Question

You are bearish on Telecom and decide to sell short 100 shares at the current market price of $50 per share.

1. How much in cash or securities must you put into your brokerage account if the broker’s initial margin requirement is 50% of the value of the short position?

2. If you earn no interest on the funds in your margin account, what will be the rate of return after 1 year if the stock is selling at (i) $60; (ii) $40; (iii) $30? Assume the stock pays no dividends.

Answer 1

Initial margin is 50% of value of short position = .5 * 50 * 100 = $2500

Short selling means Borrow shares of the security and  Sell the shares immediately at the market price. When prices decline, repurchase them and return them to whoever you borrowed them from.

Thus shares are sold at $50 and after 1 year bought at $60

1.Return=( selling price - cost price ) / cost price

= (50 - 60)/ 60 = -1/6 = - 16.67%

shares are sold at $50 and after 1 year bought at $40

2.Return=( selling price - cost price ) / cost price

= (50 - 40)/ 40 = 1/4 = 25%

shares are sold at $50 and after 1 year bought at $30

3.Return=( selling price - cost price ) / cost price

= (50 - 30)/ 30 = 2/3= 66.67%