Why do you need a margin account to short sell stocks?

By Chad Langager AAA
A:

The reason that margin accounts and only margin accounts can be used to short sell stocks has to do with Regulation T, a rule instituted by the Federal Reserve Board. This rule is motivated by the nature of the short sale transaction itself and the potential risks that come with short selling.

Under Regulation T, it is mandatory for short trades that 150% of the value of the position at the time the short is created be held in a margin account. This 150% is comprised of the full value of the short (100%), plus an additional margin requirement of 50% or half the value of the position. (The margin requirement for a long position is also 50%.) For example, if you were to short a stock and the position had a value of $20,000, you would be required to have the $20,000 that came from the short sale plus an additional $10,000, for a total of $30,000, in the account to meet the requirements of Regulation T.

The reason you need to open a margin account to short sell stocks is that shorting is basically selling something you do not own. As the short investor, you are borrowing shares from another investor or a brokerage firm and selling it in the market. This involves risk, as you are required to return the shares at some point in the future, which creates a liability or a debt for you. It is important for you to bear in mind that it's possible for you to end up owing more money than you initially received in the short sale if the shorted security moves up by a large amount. In such a situation, you may not be financially able to return the shares. Therefore, margin requirements are essentially a form of collateral, which backs the position and reasonably ensures that the shares will be returned in the future.

A margin account also allows your brokerage firm to liquidate your position if the likelihood that you will return what you've borrowed diminishes. This is part of the agreement that is signed when the margin account is created. From the broker's perspective, this increases the likelihood that you will return the shares before losses become too large and you become unable to return the shares. Cash accounts are not allowed to be liquidated - if short trading were allowed in these accounts, it would add even more risk to the short selling transaction for the lender of the shares. For further reading, see our Short Selling Tutorial and our Margin Trading Tutorial.

RELATED FAQS

  1. What is the difference between a short position and a short sale?

    Learn how short selling and short positioning are different, specifically in regards to the nature of the commodity being ...
  2. How do I build a profitable strategy when spotting a Rounding Top pattern?

    Learn a simple stock trading strategy that is designed to profit from a bearish trend reversal following the formation of ...
  3. Under what circumstances is short selling advisable?

    Find out when short selling a stock is profitable and what an investor should keep in mind before deciding to pursue a short ...
  4. Why is short selling illegal in some countries but legal in the U.S.?

    Discover why many countries around the world banned the practice of short selling financial stocks and why the United States ...
RELATED TERMS
  1. Ceded Reinsurance Leverage

    The ratio of ceded insurance balances to policyholders’ surplus. ...
  2. David Einhorn

    Known for his short selling strategy, activist investor David ...
  3. Short Call

    A type of strategy regarding a call option, which is a contract ...
  4. Total Debt-to-Capitalization Ratio

    An indicator that measures the total amount of debt in a company’s ...
  5. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  6. Leveraged Buyback

    A repurchase of significant amount of shares through the use ...

You May Also Like

Related Articles
  1. Trading Strategies

    Risk Management Techniques For Shorting ...

  2. Brokers

    Arbitrage Opportunities in Spread Betting

  3. Brokers

    The Exciting World Of The Top Spread ...

  4. Technical Indicators

    How To Use Technical Indicators To Master ...

  5. Trading Strategies

    Margin Investing: Big Risk, Big Reward

Trading Center