Short selling

The very essesnce of business, of production, is the spirit of an advance.  When a bank grants a loan to an entrepreneur, what he is essentially doing is transferring a bundle of material goods and services to the service of the entrepreneur.  The bank is advancing to the entrepreneur command over economic resources now in the hope of an enhanced flow of goods and services in the future.

But in a short sale there is no advance.  As it happens on an exchange such as the NYSE with a broker like Lehman, when you sell stock short you get the money equal to the value of the sale.  We are told we are borrowing the stock from the brokerage, and selling it in the present, anticipating a fall in its price.  When and if the price indeed falls, we buy back the stock from the market, and return it to the brokerage.  We sell high, and buy back low.  The difference between what you got for selling the stock and what you paid for buying it back is your “return”.  I put the word advisedly in quotes, because a return as such cannot be defined for a short sale.  There is no advance of money, which when invested wisely, yields a physical or value surplus. 

To take the matter a step further, imagine that the money you got when shorting the stock was invested in buying or going long another stock.  And that long stock went up and up.  Can you calculate a return for the above transaction?

To try and clarify matters, we propose to consider the case of a short sale not of stock, but of a house.  What happens in such a case?  Must find out.

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2 Responses to “Short selling”

  1. joshi Says:

    the simplest way to understand this returns is to use futures. consider the eurostoxx futures maturing a month from now. if you want to short this index, you sell the contract at the price today – if that is a higher price than where it settles at the end of the month, the difference is your profit. in effect, you have made a bet with the other side to your trade that the price is going to be lower a month from now. to make sure you can honor your bet, you have to put up an initial margin, which you have to keep topping up on any day the trade declines against you and can withdraw from on the day the trade goes for you. your return is then the profit or loss at month end computed as a percentage of the initial margin.

    its exactly the same with stocks – if you borrow a stock, you have to put up an initial margin to ensure you can bear any loss – the return is calculated as a percentage of this initial margin.

  2. sxray Says:

    Your explanation of the futures trade is clear and well understood. But in the context of this discussion, IMO, extraneous. Why complicate matters (unless I haven’t got the point at all, which I don’t think is the case.) The point I was trying to make is that there is, in the short sale I am talking about, no margin requirement. In fact, you earn money at a low rate of interest on the proceeds from the stock. You cannot use a margin for the denominator in your returns calculation.

    This was the practice at the hedge fund I used to work for, based out of New York. Their primebrokers were then, Lehman (RIP).

    If they had to borrow a stock, they did not have to pay a margin. I did the reports myself, so I know.

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