Proper formula to calculate gain on a short trade?

[Lyehopper]

According to this page on Investopedia.com, you ARE supposed to use the price of the short sale as the denominator when figuring the % gain or loss, which is not the way I have it on your spreadsheet, but it is the way we've been doing it on the POTW.

So according to these guys if you short at 100 and cover at 80 your gain is 20% and not 25%. It's kind of strange logic, and I don't fully agree with it, but I'm willing to bend if that's the way it's commonly figured.

Here's the quote from the above-linked page:

"To calculate the return on a short sale, all you need to do is calculate the difference between the proceeds from the sale and the cost to close the position. This value is then divided by the initial proceeds from the sale of the borrowed shares. If you were to short 100 shares at $50 a share, the total proceeds of the sale would be $5,000 ($50*100) and that amount would be deposited in the shorts account. If the stock fell to $30 and you closed your position, it would cost you $3,000 ($30*100), which would leave you with $2,000 in your account ($5,000-$3,000). The return that is calculated would be $2,000 divided by the initial proceeds from the sale of the borrowed shares and would be equal to a 40% return."

Good news is the POTW is correct.... Bad news is we gotta change my Roundup spreadsheet.... Good news is you made us really think about this!

[Rob]

Go figure ....

Good news is the POTW is correct.... Bad news is we gotta change my Roundup spreadsheet.... Good news is you made us really think about this!

Well, Douggie's the one who brought up the question. I never really thought about it until I started creating that spreadsheet. When I named one column Cost and another Proceeds, it just didn't seem logical to enter proceeds from a short sale in the Cost column. It still doesn't seem right to me, but I'll switch it.

[jiesen]

Lye,
Getting serious now. I'd say Quasi-Ernie thinks this way. #1 In his mind he has $100 to lose or to make money with. He makes $20. He has made 20% on his money. #2 In his mind he has $100 to lose or make more money with. He loses $20. He has lost 20% of his money, but must make 25% on his next transaction to get back to where he started. This brings up another question. Quasi has a bad string of short calls and loses 20% on each trade. How many trades can he make without going broke?

billyjoe

depends mainly on the commission. but if commission is included in the 20%, and you can split a penny infinitesimally, then you could go on losing 20% ad infinitum. (as long as you can find a broker who'll make a trade for a 1/1000000000000000 cent commission)

but also depends on how broke is broke... I did the math just for fun:
10 trades of -20% (starting from $100) and you're too broke to place an order at Schwab.
12 trades, and you can't even trade at Scottrade
21 trades and you don't have a dollar to your name
28 trades and you don't have 2 dimes to rub together
45 trades and the number of pennies you possess rounds to 0
3196 trades and even Excel can't calculate how broke your ass is

[billyjoe]

Jiesen,
What is the lowest priced stock you've actually purchased?

billyjoe

[jiesen]

I placed an order once for a 0.0002 stock. But my price was 0.0001 and it didn't fill.

But the lowest fill I actually got was 0.18 for GFCI.

[IIC]

Jiesen,
What is the lowest priced stock you've actually purchased?

billyjoe

I'd have to go back a few years and check...Cannot remember the ticker off the top of my head...but it was .21sh...I made .02 sh.

[scifos]

I've always calculated shorts this way:

(Cover Price - Short Price)/Short Price

So I agree with Ski

[DSteckler]

Don't forget to subtract the margin interest from the gain or add it to the loss.

[Rob]

Surely You Jest

Don't forget to subtract the margin interest from the gain or add it to the loss.

Dave, surely you jest. People will just have to make that menatal adjustment as they go along.

[ParkTwain]

You're doing a buy and sell, only in reverse order in time. The cover is the buy and the short is the sell. Shorting a $100/sh stock and covering at $50/sh is a 100% profit per share, before commisions, paid dividends (if any), and margin interest paid.

Regarding the discussion on the Investopedia.com page:

//
The reason why short sales are limited to a return of 100% is that they create a liability the moment they are instituted. While the liability does not translate into an investment of real money by the short seller, it is essentially the same thing as investing the money: it is a liability that needs to be paid back in the future. The short seller is hoping that this liability will disappear, and for this to happen the shares would need to go to zero. This is why the maximum gain on a short sale is 100%. The maximum amount the short seller could ever take home is the proceeds from the short sale - in the case of our example, $5,000 (the same amount as the initial liability). When calculating the return of a short sale, you need to compare the amount the trader gets to keep to the initial amount of the liability.
//

I would not be inclined to think of a liability as an investment. (I would think that an investment should be defined as the exchange of assets in one form into another form for purposes of achieving an eventual gain in value.) Rather, what I *do* (cover a short position at hopefully a much lower price per share) with the proceeds of a liability is the investment. (I might instead open a new long position using margin.) I suppose that Investopedia.com's discussion is the standard way of explaining this transaction on Wall St., but I don't agree with it. I do understand that under that way of thinking a short position is limited to a 100% maximum gain.

Of course, there are Wall St. players who might take on an enormous short position in a stock, while at the same time buying some amount of floorless convertible debentures (a money-raising instrument made available to a company that has little means of otherwise raising funds in the open market and which give the hold the right to convert the debentures into common shares under a prescribed formula, usually involving the event of the common share price falling below some threshold for some number of consecutive market sessions). After making these two transactions (shorting the common and buying the convertible debentures), the game becomes making the common shares fall below the threshold price per share via "short operations" such as pounding down the common's bid in the open market, putting out negative press releases about the company, etc. If the price activity causes a triggering of the conversion of the debentures into newly minted common shares (with the accompanying dilution of common share value, thus leading additional downward pressure on the PPS of the common shares in the open market), the holder of the now converted debentures now has at least some of shares needed to cover the short position.

[Rob]

Thank You

You're doing a buy and sell, only in reverse order in time. The cover is the buy and the short is the sell. Shorting a $100/sh stock and covering at $50/sh is a 100% profit per share, before commisions, paid dividends (if any), and margin interest paid.

Exactly the point I've been making, but evidently—in this case anyway—the market, the brokers, etc. all choose to do it the way that doesn't make sense, so that's the way I set up Lye's spreadsheet.

[ParkTwain]

I have a small paperback book that is a reprint of a document that was published in the 1920s, I believe, author unknown (but attributed to Bernard Baruch of Wall St fame and later governmental service), that is a defense of short selling of securities. In that book, the author states straightaway that a short sale is simply a conventional buy/sell transaction where the two ends of the transaction are reversed in time.

Here is the book available from Amazon:

http://www.amazon.com/gp/product/188327219X/qid=1147468050/sr=1-5/ref=sr_1_5/103-0827782-3635012?s=books&v=glance&n=283155