You Believe The Stock In Freeze Frame Co Is Going To Fall So

You Believe The Stock In Freeze Frame Co Is Going To Fall So You Sho

You believe the stock in Freeze Frame Co. is going to fall, so you short 850 shares at a price of $58. The initial margin requirement is 30 percent. Construct the equity balance sheet for the original trade, including assets and liabilities, with all amounts as positive values and without the dollar sign.

Next, construct an equity balance sheet for when the stock price drops to $54 per share. Calculate your margin percentage at this point.

Then, determine your effective annual return if you close your short position after 4 months at the $54 price.

Finally, construct an equity balance sheet if the stock price increases to $63 per share, calculate your margin percentage, and determine your effective annual return if you cover the short position after 4 months at this higher price.

Paper For Above instruction

Investing strategies like short selling require a comprehensive understanding of margin requirements, equity calculations, and return on investment over different stock price movements. In this paper, I will analyze a hypothetical short-selling scenario on Freeze Frame Co., constructing balance sheets at various stock prices, calculating margins, and estimating effective annual returns based on different exit points. This analysis provides insight into the risks and potential rewards of short selling and highlights the importance of financial metrics for investors.

Balance Sheet Construction at Original Price ($58)

When initiating the short sale of 850 shares at $58 per share, the proceeds from the sale are calculated as 850 × 58 = $49,300. The initial margin requirement is 30%, so the investor must deposit 30% of the total value of the short position as equity, which is 0.30 × $49,300 = $14,790. The short position liability reflects the obligation to buy back 850 shares at the current market price. The initial equity includes the margin deposit made by the investor, and the assets include the proceeds of the sale.

At the inception of the trade, the total assets equal the sum of the proceeds plus initial margin deposit, and the liabilities reflect the short position. The equity is the investor's margin deposit.

Balance Sheet when Stock Price Declines to $54

If the stock price falls to $54, the market value of the short position becomes 850 × 54 = $45,900. The equity now is the difference between the proceeds from the initial short sale and the current market value of the shares, plus the initial margin deposit. Calculations:

Market value of short position = $45,900

Accumulated loss = (Initial sale proceeds - Current market value) = $49,300 - $45,900 = $3,400

Account equity = Initial margin deposit + unrealized gain = $14,790 + $3,400 = $18,190

Margin percentage is defined as:

Margin = (Account equity / Current market value of short position) × 100 = ($18,190 / $45,900) × 100 ≈ 39.63%

Effective Annual Return from Short Covering at $54 in 4 Months

The profit is the difference between the initial proceeds and the buyback cost: $49,300 - $45,900 = $3,400. Since the initial investment is the margin deposit of $14,790, the return over 4 months is:

Return over 4 months = (Profit / Margin deposit) × 100 = ($3,400 / $14,790) × 100 ≈ 22.98%

Annualized return is calculated as:

Effective annual return = [(1 + 0.2298)^(12/4)] - 1 ≈ [(1.2298)^3] - 1 ≈ 1.858 - 1 = 0.858 or 85.80%

Balance Sheet at Stock Price Rises to $63

If the stock price increases to $63 per share, the market value of the short position rises to 850 × 63 = $53,550. The unrealized loss is:

Loss = $53,550 - $49,300 = $4,250

Account equity = Initial margin deposit - unrealized loss = $14,790 - $4,250 = $10,540

Margin percentage is:

Margin = ($10,540 / $53,550) × 100 ≈ 19.66%

Effective Annual Return when Covering at $63 after 4 Months

Loss incurred = $53,550 - $49,300 = $4,250

The total profit in this case is negative, indicating a loss. The return over 4 months is:

Return = (-$4,250 / $14,790) × 100 ≈ -28.74%

The annualized return is:

Effective annual return = [(1 - 0.2874)^(12/4)] - 1 ≈ (0.7126)^3 - 1 ≈ 0.362 - 1 ≈ -63.8%

These calculations illustrate the risks of short selling; a decline in stock price results in a gain, while an increase leads to losses, often amplified when annualized.

Conclusion

Short selling is a sophisticated investment strategy that requires careful attention to margin requirements, potential risks, and profit calculations across different scenarios. In this analysis, the balance sheets, margins, and returns have been calculated for declines and increases in stock price, demonstrating the importance of monitoring market movements and understanding leverage. While profitable if the stock drops, short selling exposes investors to significant potential losses if the price rises, emphasizing the need for diligent risk management.

References

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