Overview

In this chapter, we will delve into the concept of short-selling, a technique used by investors to profit from the declining value of an asset. We will explore how short-selling works and calculate the net profit that can be generated from a short sale, particularly when dealing with dividend-paying stocks. Understanding short-selling is crucial as it provides insights into the strategies investors employ to capitalize on market downturns.

Short-Selling Explained

Short-selling involves borrowing an asset, such as a stock, from a broker and immediately selling it on the market, with the intention of buying it back at a lower price in the future. The difference between the selling price and the eventual repurchase price represents the potential profit or loss.

Calculating Net Profit of Short Sale

To calculate the net profit of a short sale, consider the following steps:

1) Borrow and sell the stock at the initial price (short entry).

2) Buy back the stock at a later time (short exit) to return it to the lender.

3) Calculate the difference between the initial selling price and the repurchase price.

4) Adjust for any dividends paid by the stock during the period.

Example: Let’s assume you short-sell 100 shares of a company’s stock at USD 50 per share. Later, you repurchase the shares at USD 40 per share after a certain period during which the company paid a USD 1 dividend per share.

Short Entry:

• Initial Selling Price: 100 shares * USD 50/share = USD 5,000

Short Exit:

• Repurchase Price: 100 shares * USD 40/share = USD 4,000
• Dividend Adjustment: 100 shares * USD 1/share = USD 100

Net Profit Calculation:

• Net Profit = Initial Selling Price - Repurchase Price + Dividend Adjustment
• Net Profit = USD 5,000 - USD 4,000 + USD 100 = USD 1,100