In a short sale transaction, the investor borrows shares and sells them on the market in the hope that the share price will decrease and he or she will be able to buy them back at a lower price. The proceeds of the sale are then deposited into the short seller's margin account. Because short selling is essentially the selling of stocks that are not owned, there are strict margin requirements. This margin is important, as it is used for collateral on the short sale to better insure that the borrowed shares will be returned to the lender in the future.

While the initial margin requirement is the amount of money that needs to be held in the account at the time of the trade, the maintenance margin is the amount that must be in the account at any point after the initial trade.

Under Regulation T, the Federal Reserve Board requires all short sale accounts to have 150% of the value of the short sale at the time the sale is initiated. The 150% consists of the full value of the short sale proceeds (100%), plus an additional margin requirement of 50% of the value of the short sale. For example, if an investor initiates a short sale for 1,000 shares at $10, the value of the short sale is $10,000. The initial margin requirement is the proceeds $10,000 (100%), along with an additional $5,000 (50%), for a total of $15,000.

Maintenance margin requirement rules for short sales add a protective measure that further improves the likelihood that the borrowed shares will be returned. In the context of the NYSE and NASD, the maintenance requirements for short sales are 100% of the current market value of the short sale, along with at least 25% of the total market value of the securities in the margin account. Keep in mind that this level is a minimum, and it can be adjusted upward by the brokerage firm. Many brokerages have higher maintenance requirements of 30-40%. (In this example, we are assuming a maintenance margin requirement of 30%.)

Figure 1

In the first table of Figure 1, a short sale is initiated for 1,000 shares at a price of $50. The proceeds of the short sale are $50,000, and this amount is deposited into the short sale margin account. Along with the proceeds of the sale, an additional 50% margin amount of $25,000 must be deposited in the account, bringing the total margin requirement to $75,000. At this time, the proceeds of the short sale must remain in the account; they cannot be removed or used to purchase other securities.

The second table of Figure 1 shows what happens to the short seller if the stock price increases and the trade moves against him or her. The short seller is required to deposit additional margin in the account when the total margin requirement exceeds the original total margin requirement of $75,000. So, if the stock price increases to $60, then the market value of the short sale is $60,000 ($60 x 1000 shares). The maintenance margin is then calculated based on the market value of the short, and it is $18,000 (30% x $60,000). Added together, the two margin requirements equal $78,000, which is $3,000 more than the initial total margin that was in the account, so a $3,000 margin call is issued and deposited into the account.

Figure 2

Figure 2 shows what happens when the stock price decreases and the short sale moves in the short seller's favor: the value of the short sale decreases (which is good for the short seller), the margin requirements also change, and this change means the investor will start to receive money out of the account. As the stock heads lower and lower, more and more of the margin in the account - the $75,000 - is released to the investor. If the price of the stock falls to $40 a share, the short sale value will be $40,000, down from $50,000. Whenever the price falls, investors are still required to have an additional 50% in the account - so the additional margin required in this case will be $20,000, down from $25,000. The difference between the initial margin requirement total and the margin requirement total as the price falls is released to the short seller. In this example, the amount released when the price falls to $40 is $15,000, which consists of the $10,000 drop in the short sale value and the $5,000 drop in the additional margin requirement. The short seller could then use this money to purchase other investments.

To learn more, see our Short Selling Tutorial and our Margin Trading Tutorial.

  1. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>
  2. Why do some people claim the Federal Reserve is unconstitutional?

    The U.S. Constitution does not mention the need for a central bank, nor does it explicitly grant the government the power ... Read Full Answer >>
  3. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  4. How does a broker decide which customers are eligible to open a margin account?

    Brokers have the sole discretion to determine which customers may open margin accounts with them, although there are regulations ... Read Full Answer >>
  5. Are there leveraged ETFs that follow the retail sector?

    There are many exchange-traded funds (ETFs) that track the retail sector or elements of the retail sector, and some of those ... Read Full Answer >>
  6. What is the interest rate offered on a typical margin account?

    Interest rates on margin accounts vary according to the size of the loan and the brokerage firm being used. Generally, interest ... Read Full Answer >>
Related Articles
  1. Economics

    What's the 1913 Federal Reserve Act?

    The 1913 Federal Reserve Act was a pivotal congressional act that helped establish the Federal Reserve System as it exists today. It is one of the United States financial system’s most influential ...
  2. Professionals

    Will Interest Rates Rise at the Next Fed Meeting?

    Everyone wants to know what the Federal Reserve will do next, but the Fed doesn't even know what it's next move will be.
  3. Mutual Funds & ETFs

    Using Short ETFs to Battle a Down Market

    Instead of selling your stocks to get gains, consider a short selling strategy, specifically one that uses short ETFs that help manage the risk.
  4. Investing

    Watch Your Duration When Rates Rise

    While recent market volatility is leading investors to look for the nearest exit, here are some suggestions for bond exposure in attractive sectors.
  5. Investing

    A Quick Explanation of How Short Selling Works

    Explanations of short selling can be hard to grasp. Here is a quick, realistic example.
  6. Chart Advisor

    Downtrending Stocks to Short or Sell

    These stocks are trending lower and currently near a short sale areas, based on breaks lower and falling stock indexes.
  7. Professionals

    3 ETFs to Play the Fed's Interest Rate Decision

    These three ETFs offer strong ways to play the Federal Reserve's decision not to raise rates.
  8. Chart Advisor

    Second Chance Entries Into Completed Double Tops

    These stocks have already completed double top chart patterns, and are right now offering a second chance to trade it.
  9. Stock Analysis

    Coca-Cola Vs. PepsiCo: Which Stock Should You Buy?

    Learn about the bull case for Coca-Cola and PepsiCo. Find out which is more attractive for investors, and learn about the strengths of each company.
  10. Forex Strategies

    This Might Be the Best Time to Buy Colombian Pesos

    Signs are growing that energy markets are bottoming out, allowing the Colombian Peso to recover its value in a profitable trend against the U.S. Dollar.
  1. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin ...
  2. Equity

    Equity is the value of an asset less the value of all liabilities ...
  3. Debt/Equity Ratio

    Debt/Equity Ratio is debt ratio used to measure a company's financial ...
  4. Marginable

    Definition of "marginable."
  5. Bear Closing

    Purchasing a security, currency, or commodity in order to close ...
  6. Borrowing Power Of Securities

    The value associated with being able to invest in securities ...

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!