Question

 

1. Suppose you short-sell 100 shares of IBM, now selling at $200 per share.

 

a. What is your maximum possible loss?

b. What happens to the maximum loss if you simultaneously place a stop-buy order at $210?

2. Old Economy Traders opened an account to short-sell 1,000 shares of Internet Dreams at $40. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share.

1. What is the remaining margin in the account?

b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?

3. You are bullish on Telecom stock. The current market price is $50 per share, and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker and invest $10,000 in the stock. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately.

4. 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. How high can the price of the stock go before you get a margin call if the maintenance margin is 30% of the value of the short position?

 

 

Answer 1

1a)

Theoretically the maximum loss possible on short selling is unlimited. the price of IBM can keep on rising, and to that extent the loss on the short position also rises.

however, practically this is not possible-since margin requirements are there in place- and when the maintenance margin limit is breached-additional margin needs to be deposited to hold on to the loss making position as the price of IBM rises. If additional margin is not provided- the shares will be squared off. in that case the loss will be to the extent of difference between the sell price and the square off buy price- multiplied by the number of shares short sold

1b) if a buy stop is placed at 210, the maximum loss possible is $ 1000

The loss will be $1000- provided buy order gets filled.

2 a)   Current margin is $8000

First we need to find the initial margin- which will be 50% of the short sale value

from This margin the loss on account of an increase in price by $10 is to be reduced

the dividend of $2 that is owed to the lender of the shares is also a loss- it is to be reduced from the margin

the resultant figure will be the current margin.

this current margin when divided by the current portfolio value(no. of shares shorted X current market price)   will give us the current margin %

Workings are shown below

2b)    Since the current Margin is only 16% as computed above-as against the required maintenance margin of 30% OLD economy will Receive a margin Call

3)      A fall in priceof the telecom stock below $ 35.71- will initiate a margin call

We need to find the Initial Margin% first.

4) a) Initial margin is $ 2,500

b)