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.

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