PrivateBanker is normally spot on but this time he copied some CFA curriculum from Investopedia that was wrong and then added some odd stuff that was wrong.
1) Uptick rule doesn't exist anymore. The uptick rule was done away with 10 years ago. There is a very limited uptick rule in place now but it is nothing like allowing trading in an " "up market" where the market is appreciating".
2) Calculating ROI for individual positions is usually silly and really only works for buying assets.
3) Not clear why PB would say that the buyback price closing the position was the amount invested in the short sale. That surely says that your return on a short sale double counts gains on the sale. About the only sensible number to put there would be the amount of money needed for margin.
4) Short sales often have borrow fees for professional investors that are not included above.
I respect PB a lot but this one didn't work out well.
I can positively assure you that there are investments in the world that will destroy any ROI calculation. A forward contract often costs 0 to enter including no margin. Does that mean the ROI is always +/- infinity?
A short sale order, or a stock sold short, is an order to sell shares that a client does not own. As a result, the trader must borrow the stock from an existing client, sell the shares of the security and then buy the stock again to replace the shares he borrowed. In doing this, there are three rules that must be followed:
1. A short sale order can only be done in what is known as an "up market" where the market is appreciating, not declining. This is known as the uptick rule.
2. If a dividend is paid on the shares, the investor selling the shares short pays the dividend to the investor he borrowed the shares from.
3. An investor cannot borrow shares to sell short without providing some sort of collateral.
So your return is the return is similar to returns for any other investment, it's just that you sell first, and buy later.
(sale price - any dividends paid to the owner of the stock you borrowed - purchase price) / purchase price
For example, a client wants to sell 100 shares of Newco short at $45. The trader sells 100 shares he borrowed from another investor at $45. The amount from the sale goes to the investor selling the shares short. The investor is hoping the shares go below the $45. If, for example, the shares decline to $35, the investor already sold the shares at $45. The investor can thus repurchase the shares at $35 and replace the shares he borrowed. Excluding transaction costs, the investor had made $10 per share on the transaction.
Return: (45 - 35) / 35 = 0.28571, or about 28.57%
If, say, a $1 dividend was paid on the stock during the time horizon, you'd have to pay the lender of the stock that $1, so you'd have:
(45 - 1 - 35) / 35
= 9 / 35
= 0.25714, or about 25.7% return
you typically would not receive interest on the required margin account, nor do you PAY interest b/c it's your money. Technically, I suppose you could reduce the total return by the opportunity cost of your margin account - e.g. the amount of return you'd have received on those margin funds if you'd invested those elsewhere. Generally though, that opportunity cost is not calculated into your return. Remember, that margin money is not margin in the sense that you borrowed money to buy the stock ('buying on margin), it's basically a deposit to protect the broker in the case the stock INCREASES in price. E.g. you short sell at $45 and the price goes to $55 - you have to buy the stock back at $55 in order to return it to the original holder of the stock (the person you borrowed the stock from). The margin requirements are essentially a form of collateral, which backs the position and reasonably ensures that the shares will be returned in the future.
I understand that short-selling have some margin requirements, but would those amounts be considered part of my initial investment?
