I have been meaning to write this post for a very long time. Those who post on this board and short the stock will know this information quite well. I just have one caveat. I don’t think the rules have changed since I was a licensed stockbroker from 1982 to 1986. This example assumes the brokerage account is large and approved for all trading levels.
When one wishes to purchase 1,000 shares of Lightwave Logic at $4.20 per share, they must put up $4,200 in cash. Presumably this cash was in a money market fund earning 5.19% at Schwab. The opportunity cost on a monthly basis is therefore $18.16. After one year, this cost is $217.98.
When a short seller sells 1,000 of Lightwave Logic at $4.20 and holds the $4,200 proceeds in the same money market fund at Schwab earning 5.19%, they earn $18.16 in interest per month or $217.98 per year. The margin requirements state that the short seller must maintain 110% of the value of the short position on a daily basis. Therefore, in theory, the short seller must add $420 to the account. Now the short seller has $4,620 in the money market fund earning $19.98 per month and $239.78 per year. There are two ways to look at this scenario:
1) As I stated in the first paragraph, this is a large account with hundreds of thousands of dollars in the money market fund at all times and so this specific trade does not require any daily transfer of funds to maintain the margin requirement. Assuming the stock is at $4.20 after one year, the short seller has made $239.78 in interest income and the buyer has lost $217.98 in opportunity cost. Therefore, the short seller is ahead of the long buyer by $457.76 or roughly 10.9%.
2) The account is very small and can only afford to short 1,000 shares at $4.20. While this scenario is not possible, it is the scenario that X writes about when referring to margin calls. In this case, there is no excess balance in the account’s money market fund. The short seller was able to come up with the 10% margin requirement or $420, but has no other funds available to him. After the sale, the account has $4,620 in cash. If there were to be the PR that most of us believe is coming soon and the stock shot up to $9.20 per share, the margin requirement would jump to $10,120. That would require this broke ass short seller to deposit $5,500 within 24 hours or Schwab would buy back his short position at $9.20, close the account, and sue the short seller for the balance owed.
In both scenarios, the short seller would lose the same amount of money if the stock were to gap open, but the large account would simply absorb the loss and the small account would be in trouble. In reality, no brokerage firm would authorize the small account to participate in short selling activities. Short selling is a very risky business, but it can also be a very lucrative business. Certainly, the short seller lobby dominates the SEC to maintain the margin requirement rules skewed in their favor.
