Question

Question #5: Short-Selling (16 Points) Joshua decides to short-sell 750 shares of Tesla Inc. (TSLA), now selling at $430 per share. (a) What is Joshua's maximum possible gain? [4 Points] (b) What is Joshua's maximum possible loss? [4 Points] (c) Suppose that Joshua simultaneously places a stop-buy order for 750 shares of Tesla (TSLA) with a $485 limit. Assume that the shares can be purchased at $485 if the order is executed. What is Joshua's maximum possible loss? [8 Points]

Answer 1

However, if the stock price increases to $485 per share and the investor decides to close the short position, he will need to buy-to-cover the 750 shares from the open market at the current price of $485 per share. The loss for this short sale transaction will be $55 per share which amounts to a total loss of $41250 (excluding commissions and interest), since the stock shares were bought back at a higher price.

Short selling stocks is a strategy to use when you expect a security’s price will decline. The traditional way to profit from stock trading is to “buy low and sell high”, but you do it in reverse order when you wish to sell short. To sell short, you sell shares of a security that you do not own, which you borrow from a broker. After you short a position via a short-sale, you eventually need to buy-to-cover to close the position, which means you buy back the shares later and return those shares to the broker from whom you borrowed the shares. You can make a profit from short-selling if you buy back the shares at a lower price.

When you trade stocks in the traditional way (“buy low and sell high”), the maximum amount that you can lose is your initial investment. However, when short selling stocks, your losses are theoretically unlimited, since the higher the stock price goes, the more you could lose. You will be charged interest only on the shares you borrow, and you can short the shares as long as you meet the minimum margin requirement for the security. Review the short-selling example below to see how short selling a stock works.