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 they will be able to buy the stock back at a lower price, returning to the lender at the lower price. The proceeds of the sale are then deposited into the short seller's brokerage account.
Because short selling consists essentially of selling stocks that are borrowed and not owned, there are strict margin requirements. Margin is important, as the money is used for collateral on the short sale to better ensure that the borrowed shares will be returned to the lender in the future.
- A short sale requires margin because the practice involves selling stock that is borrowed and not owned.
- While the initial margin is the amount of margin required at the time the trade is initiated, the maintenance margin is the margin requirement during the life of the short sale.
- 150% of the value of the short sale is required as the initial margin.
- If the value of the position falls below maintenance margin requirements, the short seller will face a margin call and be asked to close the position or increase funds into the margin account.
Types of Margin
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 of $10,000 (100%), along with an additional $5,000 (50%), for a total of $15,000.
Example of Margin Requirements
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 New York Stock Exchange and the Nasdaq Stock Market, 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 the brokerage firm can adjust it upward. Many brokerages have higher maintenance requirements of 30% to 40%. (This example assumes a maintenance margin requirement of 30%.)
Below, 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 margin account. Along with the proceeds of the sale, an additional 50% margin amount of $25,000 must be deposited in the margin account, bringing the total margin requirement to $75,000. At this time, the proceeds of the short sale must remain in the account and cannot be removed or used to purchase other securities.
The second table of the above image shows what happens if the stock price increases and the trade move against the short seller, who 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 1,000 shares).
The maintenance margin is then calculated based on the market value of the short, and it is $18,000 (30% x $60,000). The two margin requirements added together 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 the funds must be deposited into the margin account or the short position (some or all of it) must be closed.
The table below 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 margin 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's account. 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.
Brokerages charge interest based on the value of the borrowed shares, and some stocks cannot be sold short when there are no shares available for short sellers (cannot be borrowed).
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.
The Bottom Line
Selling stock short is a strategy that involves borrowing shares from the broker, selling the stock, and hoping to return the shares at a lower price when the stock price falls. Short sales require margin equal to 150% of the value of the position at the time the position is initiated, and then the maintenance margin requirements come into play from that point forward. A drop in the share price will reduce the amount of margin required, while a move higher in the stock can result in a margin call if the value of the position drops below maintenance margin requirements.