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 investors come close to challenging Warren Buffett as the greatest investor ...

    Discover two legendary investors who not only challenge but perhaps exceed Warren Buffett in terms of their talent and achievements ...
  2. Are there leveraged ETFs that track the metals and mining sector?

    Understand what a leveraged ETF is, and learn about leveraged ETFs that track the metals and mining sector and are available ...
  3. What does it signify about the state of a company if it has unusually high shareholders' ...

    Understand the meaning and calculation of shareholder equity and what a high level of shareholder equity signifies about ...
  4. If I use hedging as a risk strategy, do I have to keep my eye on my portfolio all ...

    Understand the concept of hedging and learn how this key element to portfolio management can help an investor protect profits ...
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. Mutual Funds & ETFs

    Are These the Top Inverse ETFs of 2 ...

  2. Mutual Funds & ETFs

    Will the Natural Gas ETF KOLD Stay Hot?

  3. Investing

    Ready To Invest In Financial Leverage ...

  4. Options & Futures

    How To Protect A Short Position With ...

  5. Mutual Funds & ETFs

    A Guide to Using Inverse ETFs for Diversification

Trading Center