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WHEN GOOD INVESTING GOES BAD

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protect the actual owner of the borrowed securities. For instance, you can only short a sale after the price of the stock has moved upward. Therefore, if the price of XYZ common stock goes from $25 per share to $25.50/share, then you can sell it short. However, if the price declines from $25.50 per share to $25 per share, you have to wait. Another rule is that the investor has to have a certain amount of money on hand with the brokerage firm prior to executing the sale. Even short sales require some sort of deposit of capital. You just can’t walk into a firm and start selling stocks short! Finally, brokerage firms will hold the proceeds of the short sale until the borrowed stock has been replaced.

As an example, we assume that you want to short XYZ com- mon stock. You sell 500 shares short at $28 per share. Your gross sale proceed is $14,000. (Trading costs and possibly commission will be deducted.) When you go to replace the borrowed stock, the price has dropped to $25 per share, meaning you purchase the shares for $12,500. You gain $1500 on the sale of stock you never owned.

Shares sold short Selling price Proceed from sale

= 500 = $28/share = $14,000

Purchase price for 500 shares = $25/share

Total purchase price

= $12,500

Gain (loss)

= $1500

However, what happens when the market goes up instead of down? Well, then you purchase the shares at a higher price, which will give you a loss. Let’s say you sell short 500 shares of XYZ com- mon stock. The execution price for the sale is $28 per share, giving you a gross proceed of $14,000. Then you need to replace the stock. Unfortunately for you, the price has now risen to $30 per share. You purchase the stock for $15,000. Your loss is $1000.

Shares sold short Selling price Proceed from sale

= 500 = $28/share = $14,000

Purchase price for 500 shares = $30/share

Total purchase price Gain (loss)

= $15,000 = ($1000)

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