Question

1. If every stock has a 50% chance of increasing or decreasing at any given point in time, and you trade randomly, do you expect to break even?

2. You have sold short 500 shares of a stock, which is now trading for an ask/bid of $20.12/$20.10. If you want to limit your losses to 10% from this point, what type of order would you submit to the exchange? Does this guarantee you won’t lose more than 10%?

3. Explain what happens when you short a stock (what does your broker do)?

4. Define liquidity and explain which order type (market or limit) provides liquidity.

Answer 1

.1.

Answer:NO.

If you trade randomly, and if there is 50% chance of increasing or decreasing, the number of times of gain or loss are expected to be 50%. But the amount of gain/loss each time will be different. Sometimes there may be a high gain (if the stock price was high) and some times the gain may be low.

Similarly , the loss also will be sometimes high and sometimes low.

Hence , the net amount of loss or gain will not be same.It is not likely to break even.

Suppose you buy different stocks randomly at 10 occasions,

5 times the stock had gone up by an amount g1,g2,g3,g4 and g5

5 times the stock had gone down by l1,l2,l3,l4 and l5

Net gain or (loss) will be (g1+g2+g3+g4+g5)-(l1+l2+l3+l4+l5)

Total of gains and total of loss may not be equal.

Hence, we cannot expect to break even.

.2. You sold short which is now trading for an ask/bid price of $20.12/20.10. In order to limit loss to 10%, you can buy call option at strike price of $22.

You will gain through call option, if the stock price goes above $22

This gain will offset the loss in selling short.

If the stock price goes down, there will be loss from short sell trade in the stock.

This will guarantee that loss will not be beyond 10%

.3 When you short sell a stock, the broker lends the cost of the share at that time. It purchases share from the market and lends share to you. For this you need to deposit with the broker entire short sale value plus initial margin. If the share price goes up , there will be loss. For this risk of loss, the broker needs the margin in addition to short sale value.

.4 Liquidity means availability of cash at the earliest.

A market order gets executed immediately as long as there are traders to buy or sell. A market order is matched with the available quotes and gets executed immediately within seconds.

Hence market order is most liquid.

A limit order is an order to buy or sell at a specified price or better. The order will only be executed if the price matches with available quotes. The order may not get executed if the specified price do not match with the quotes. Hence it is less liquid.