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I came across the following question:

Kumar has 100 shares of ABC Co. which he bought at $ 50. The current market price is $ 140. Illustrate how Kumar using short selling can safeguard or protect his total investment from a drop in the share price.

I don't understand how to use short selling in this instance since the purchase has already been made. As I know, short selling works by selling now and buying later.

Any ideas?

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This strategy is called "shorting against the box" where you short a stock that you already own. It creates a neutral position that neither benefits nor loses if the stock increases or decreases in price. In order to do this, you'd need a seprate account since if done in the same account, your broker would net out the positions.

Once upon a time, this was a popular strategy to lock in and defer gains. However, in 1997, the SEC and FINRA established the "The Taxpayer Relief Act of 1997" which eliminated this as a valid tax deferral technique.

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The idea is that you short sell the shares now, and when the price goes down, you can buy them back cheaper. However, if the price goes further up, you’ll not make any more money.
Note that this is technically identical to simply selling the shares you have and be done; but the idea is that it delays the tax consequences of the profit.

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  • Ok. So, in this instance how can short selling be used to safeguard or protect the total investment from a drop in the share price?
    – S. Tiss
    Commented Mar 23, 2022 at 19:41
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    I don't think you can defer gains tax by shorting due to the constructive gain rule (in the US at least).
    – D Stanley
    Commented Mar 23, 2022 at 21:42
  • Yes, it is a constructive sale though there is a loophole as mentioned in your link.
    – Bob Baerker
    Commented Mar 24, 2022 at 2:28
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Kumar could keep hold of the 100 shares, and short 100 shares at the same time.

As an example, and ignoring all the trading fees involved, if the shares go down from $140 to $100, then:-

  • Kumar loses $40 x 100 = $4000 on the shares he holds.
  • Kumar gains $40 x 100 = $4000 on the shares he shorted, when he buys 100 shares back.

The reverse happens if the shares unexpectedly go up in value.

But in practice, there's no real advantage in doing that compared with selling his 100 shares at their current high price, and keeping the money until the market settles.

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  • The advantage is to lock in the gain with tax avoidance.
    – Bob Baerker
    Commented Aug 21, 2022 at 13:19
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Kumar now has 100 shares of ABS worth $140 each.

If he then short sells 100 shares, he will borrow 100 shares from someone else and sell them for $140 (that's how short selling works). If the price of the shares goes down to, say, $100, he can sell his shares for $100 and use that money to buy the short shares back for $100, closing his position.

So no matter what the price of ABC goes to, Kumar has locked in a profit of $90 per share ($140 - $50), minus transaction costs.

Why someone would do this instead of just selling their shares is not clear to me.

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    When Kumar shorts the stock at $140, his account is credited with $14k. Assuming that he hasn't withdrawn the cash or purchased another stock, he can use it to buy 100 shares when he decides to cover the short position. And even if he did, it's a margin account so he can just buy the shares, using his other equity positions as collateral, unless he wants to close the entire position. To do this, one must utilize two different brokerage accounts because otherwise, the broker nets out the +100 and -100 share positions.
    – Bob Baerker
    Commented Aug 21, 2022 at 13:17
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    The reason that people did this (called shorting against the box) was to lock in gains without realizing them. In the US, this is for the most part, no longer allowed
    – Bob Baerker
    Commented Aug 21, 2022 at 13:17
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Short sell will be a separate contract.

The gain or loss in this contract will offset with the gain or loss on the sale of 100 owned shares of ABC Co. on the expiry of the short-sell contract to give you the net gain of $ (140 – 50) = $ 90 x 100 shares = $ 9,000.

Example:
Actual price at the expiry of contract $ 130 $ 150 (a) per share
Gain / Loss $ 10 $ -10 (b) per share
Total Gain / Loss [D] $ 1,000 $ -1,000 (b x 100) on short sell contract
Sale price [A] $ 13,000 $ 15,000 (a x 100) on delivery sale of 100 shares
Cost of 100 shares [B] $ 5,000 $ 5,000 @ $ 50 x 100 shares
Gain / Loss [A-B=C] $ 8,000 $10,000
Total Gain / Loss [C + D] $ 9,000 $ 9,000
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