Example of Short Selling
We will use a simple example to show how a short sale may result in a profit irrespective of how the market moves. In this example we have $1m to invest. $200 000 is set aside as a buffer to meet any margin calls arising from the short position. We use $800 000 to buy Stock A and $800 000 to enter a short-sale agreement for Stock B. We receive $800 000 from the short sale of Stock B and invest this in a money market instrument.
We will assume that we earn 2% interest on the $1m we now have invested in cash equivalents.
In the first case the market rises by 7.5%, our long position rises by 10% giving a gain of $80 000 while our short position rises by 5% giving a loss of $40 000. Total profit from the transaction is $60 000. If on the other hand the market falls by 7.5% and our long position by 5% and our short position by 10% we get the following. The long position posts a loss for $40 000 but we make a profit of $80 000 on the short position. Total profit remains $60 000. Systematic risk has been eliminated (or at least reduced).
This does of course depend on us getting the relative movement of the two stocks correct of course but does not require us to forecast whether they will go up or down.
September 2nd, 2009