Let’s say Trader Travis has identified Fiscal Foibles, Inc. (obviously, a hypothetical stock) as an appropriate short-selling candidate whose accounting shenanigans are poised to catch up with it. Travis decides to short 100 shares of the company, currently trading at $100. Here are the steps involved in the short selling process:
- Travis places the short sale order through his online brokerage account or financial advisor. Travis must declare the short sale as such when entering the order, since an undeclared short sale amounts to a violation of securities laws. He would also need to ensure that he has a minimum of $5,000 (50% of $100 X 100 shares) as capital in his margin account prior to making the short trade.
- Travis’s broker will attempt to borrow the shares from a number of sources: its own inventory, from the margin accounts of one of its clients, or from another broker-dealer. The Securities and Exchange Commission (SEC)’s Regulation SHO, which went into effect in January 2005, imposes a “locate” requirement on a broker-dealer prior to making a short sale. This requires a broker-dealer to have reasonable grounds to believe that the security to be shorted can be borrowed, so that it can be delivered to the buyer on the date that delivery is due.
- Once the shares have been borrowed or “located” by the broker-dealer, they will be sold in the market and the proceeds deposited in Travis’s margin account.
Travis’s margin account now has $15,000 in it, $10,000 from the short sale of 100 shares of Fiscal Foibles at $100, plus $5,000 (50% of $10,000) as Travis’s margin deposit.
Let’s say that the next day the stock is trading at $110. Since the margin account has to hold a minimum of 150% of the current price of the stock that has been shorted, the maintenance margin based on the market price is now $5,500 (50% x 100 x $110). Travis had already contributed $5,000 as margin when the short sale was made, but the maintenance margin level of $5,500 means that his account balance is deficient by $500. He will, therefore, receive a margin call from his broker demanding that the margin shortfall be rectified immediately. Travis will have to inject an additional $500 into the margin account to meet the maintenance margin requirement.
Let’s say that Fiscal Foibles trades between $100 and $110 for the next few days, and after a week, declines to $90. Travis decides to close out the short position by buying back the 100 shares that were sold short, at a total cost of $9,000. Therefore, his gross profit (before costs and commissions) would be $1,000.
On the other hand, suppose Fiscal Foibles decides to clean up its act, as a result of which the stock spikes to $120. At this price, Travis decides to close out his short position rather than run the risk of mounting losses. In this case, his loss would be $2,000 ($10,000- $12,000).Short Selling Strategies and Margin
Financial AdvisorA maintenance margin is the minimum amount of equity that must be kept in a margin account.
InvestingInitial margin is the percentage of a stock’s price an investor must have in his account to buy that stock on margin.
Financial AdvisorInvesting on margin can be profitable but it's a risky play that needs care.
TradingThis strategy can help in market downturns, but it's not for inexperienced traders.
TradingFind out what your broker is doing with your securities when you invest on margin.