A margin account is created by a broker for a customer—essentially lending the customer cash to buy securities. Typically, the broker will set up limits and restrictions as to how much the customer can purchase. These limits are usually more than most customers would be able to purchase on their own. Margin accounts also come with interest rates due payable to the broker, so a margin account could be considered a short-term loan. A margin account can be kept open for as long as a customer wants, as long as the obligations to the broker are still being met.
What Are Margin Accounts Used For?
When you use the margin account to purchase securities, you're buying on margin. The reason 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. More on that below. This rule is motivated by the nature of the short sale transaction itself and the potential risks that come with short selling.
Regulation T (or Reg T) was established by the Fed in order to regulate the way brokers lend to investors. It requires short trades to have 150% of the value of the position at the time the short is created and be held in a margin account. This 150% is made up of the full value, or 100% of the short plus an additional margin requirement of 50% or half the value of the position. In case you were wondering, the margin requirement for a long position is the same.
Here's an example. If you were to short a stock and the position had a value of $20,000, you would be required to have a total of $30,000 in the account to meet the requirements of Regulation T—$20,000 from the short sale plus the additional $10,000.
Margin Account as Security
The reason you need to open a margin account to short sell stocks is that shorting is basically selling something you do not own. The margin requirements essentially act as a form of collateral, or security, which backs the position and reasonably ensures the shares will be returned in the future.
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, creating a liability or a debt for you. And it is 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 that situation, you may be financially unable to return the shares.
Liquidating Your Position
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 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.)
The Bottom Line
If you are going to short stocks, you will be required to open up a margin account—a requirement by Regulation T. This was created by the Federal Reserve to regulate the way brokers lend to their customers. Having one open when you're shorting stocks takes away from the risk associated with trading and gives security to the broker.