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. When short selling a stock, how long does a short seller have before covering?

    The lender of the shares in a short sale has the ability to request the shares be returned at any time, with minimal notice, ... Read Answer >>
  2. What is the difference between a short position and a short sale?

    Learn how short selling and short positioning are different, specifically in regards to the nature of the commodity being ... Read Answer >>
  3. How long can a trader keep a short position?

    Learn whether there are any limitations on how long may an investor hold a short position, and explore the costs associated ... Read Answer >>
  4. How long can you short sell for?

    In theory, you could keep a short position open indefinitely, but in practice, a lender can demand you "buy to cover" the ... Read Answer >>
Related Articles
  1. Investing

    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.
  2. Investing

    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.
  3. Trading

    Short interest: What it tells us

    Whether you agree with the overall sentiment or not, short interest is a data point worth adding to you overall analysis of a stock.
  4. Financial Advisor

    The 5 Most Shorted NYSE Stocks (VALE, CHK)

    Understand what a short sale is and why people would want to initiate a short strategy. Learn about the top five most shorted stocks on the NYSE.
  5. Difference Between Short Selling And Put Options

    Short selling and put options are used to speculate on a potential decline in a security or index or hedge downside risk in a portfolio or stock.
RELATED TERMS
  1. Credit Balance

    In a margin account, A credit balance is the sum of proceeds ...
  2. Short Sale

    A short sale involves borrowing shares in anticipation of a price ...
  3. Minimum Margin

    Minimum margin is the initial amount required to be deposited ...
  4. Short Selling

    Short selling is the sale of a security that is not owned by ...
  5. Net Short

    Net short is a portfolio or trading position leveraged to an ...
  6. Short Interest Ratio

    A sentiment indicator that is derived by dividing the short interest ...
Hot Definitions
  1. Receivables Turnover Ratio

    Receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting ...
  2. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  3. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  4. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  5. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  6. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
Trading Center