Question

You just sold short 1,050 shares of Wetscope, Inc., a fledgling software firm, at $64 per share. You cover your short when the price hits $54.50 per share one year later. If the company paid $0.81 per share in dividends over this period, what is your rate of return on the investment? Assume an initial margin of 70 percent.

Answer 1

When a stock is sold short, it means the stock has been sold by an investor who didn't actually possess the stock but borrowed the stock from the broker and sold. The same stock has to be bought later to cover the position. Dividends need to be paid by the investor who sold the stock short. Profit is made when the stock price falls later.

The initial value of stock sold = 1050*64 = $ 67,200.

The equity amount put in = initial margin*initial value of stock sold = 0.70*67,200 = $47,040.

The dividend has to be paid and the stock has to be bought later.

Thus, the total cost of closing the position = 1050*(54.50+0.81) = $58,075.50

Thus, the profit made = amount received when sold short - amount paid to close the position

Profit = $67,200- 58,075.5 = $9124.50

Rate of return = Profit / equity put in = 9124.50/47,040 = 0.19397321 or 19.40%

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