A:

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%.)

shortsaleincrease1.gif
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.

shortsaledecreases1.gif
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.

RELATED FAQS
  1. Why do you need a margin account to short sell stocks?

    The reason that margin accounts and only margin accounts can be used to short sell stocks has to do with Regulation T, a ... Read Answer >>
  2. What does it mean when I get a maintenance margin call?

    Understand how maintenance margin calls work, and learn about how margin requirements are different for trading stock versus ... Read Answer >>
  3. What are my options when I get a margin call?

    Understand what a margin call means and the two primary options for meeting a margin call, such as depositing additional ... Read Answer >>
  4. What is the difference between initial margin and maintenance margin?

    Learn the difference between an initial margin requirement and a maintenance margin requirement and how these affect an investor's ... Read Answer >>
  5. How much can I borrow with a margin account?

    Understand the basics of margin accounts and buying on margin, including what amount investors can typically borrow for purchases ... Read Answer >>
  6. What are the different types of margin calls?

    Learn the differences between margin calls and fed margin calls while reviewing the definitions of each and how to satisfy ... Read Answer >>
Related Articles
  1. Professionals

    Buying on Margin and Maintenance Margin

    CFA Level 1 - Buying on Margin and Maintenance Margin. Learn the process of buying stock on margin. Discusses the role of a brokerage firm and the possibility of a margin call.
  2. Markets

    Intermediate Guide To E-Mini Futures Contracts - Margin

    Margin is essentially a loan that a brokerage firm extends to a client (the trader or investor) that is used for the purchase of trading instruments. Margin trading allows traders and investors ...
  3. Active Trading Fundamentals

    Short Selling: Why Short?

    Generally, the two main reasons to short are to either speculate or to hedge. When you speculate, you are watching for fluctuations in the market in order to quickly make a big profit off of ...
  4. Investing

    Buying on Margin

    When an investor buys on margin, he or she pays a portion of the stock price – called the margin -- and borrows the rest from a stockbroker. The purchased stocks then serve as collateral for ...
  5. Options & Futures

    Margin Trading: Conclusion

    Here's the bottom line on margin trading: You are more likely to lose lots of money (or make lots of money) when you invest on margin. Now let's recap other key points in this tutorial: ...
  6. Options & Futures

    Margin Trading: What Is Buying On Margin?

    The Basics Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able ...
  7. Professionals

    Market Value of a Short Position

    Market Value of a Short Position
  8. Professionals

    Margin Accounts

    Margin Accounts
  9. Investing Basics

    The Basics Of Short Selling

    Short sellers enable the markets to function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
  10. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
RELATED TERMS
  1. Minimum Margin

    The initial amount required to be deposited in a margin account ...
  2. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin ...
  3. Credit Balance

    In a margin account, the amount of funds deposited in the customer's ...
  4. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  5. Buying On Margin

    The purchase of an asset by paying the margin and borrowing the ...
  6. Excess Margin Deposit

    Funds deposited in a trading account beyond what is required ...

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  5. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  6. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
Trading Center