Credit Balance

What is a 'Credit Balance'

A credit balance in a margin account is the amount of funds deposited in the customer's account following the successful execution of a short sale order. The credit balance amount includes both the proceeds from the short sale itself and the specified margin amount the customer is required to deposit under Regulation T.

BREAKING DOWN 'Credit Balance'

There are two types of investment accounts used to buy and sell financial assets – a cash account and a margin account. A cash account is a basic trading account in which an investor can only make trades with his available cash balance. If an investor has $500 in the account, then he can only purchase shares worth $500, inclusive of commission – nothing more, nothing less. A margin account allows an investor or trader to borrow money from the broker to purchase additional shares, or int he case of a short sale, to borrow shares to sell. An investor with a $500 cash balance may want to purchase shares worth $800. In this case, his broker can lend him the additional $300 through a margin account.

While a long margin position has a debit balance, a margin account with only short positions will show a credit balance. The credit balance is the sum of the proceeds from a short sale and the required margin amount under Regulation T. In short selling, an investor essentially borrows shares from his or her broker and then sells the shares on the open market, hoping to buy them back from the open market at a lower price at a later date, and then return the shares to the broker, pocketing any excess cash. When the shares are first sold short, the investor receives the cash amount of the sale in his or her margin account.

Since the shares which are sold are borrowed, the funds that are received from the sale technically do not belong to the short seller. The proceeds must be maintained in the investor's margin account as a form of assurance that the shares can be repurchased from the market and returned to the brokerage house. In effect, the funds cannot be withdrawn or used to purchase other assets. Since the risk of loss from short selling is high given that the price of a share can increase indefinitely, a short seller is required to deposit additional funds in the margin account as a buffer in case the stock increases to the point of loss for the seller. Some brokers stipulate the margin requirement on short sales to be 150% of the value of the short sale. While 100% of this value already comes from the short sale proceeds, the remaining 50% must be put up by the account holder as margin. The 150% margin requirement is the credit balance required to short sell a security.

Credit Balance Example

Say, an investor shorts 200 Facebook (FB) shares at $180/share for total proceeds of $36,000. The margin requirement of 150% means that the investor has to deposit 50% x $36,000 = $18,000 as initial margin into the margin account, for a total credit balance of $18,000 + $36,000 = $54,000.

The credit balance in a short margin account is constant; it does not change regardless of price volatility. The two factors that change with market fluctuations are the value of equity (or margin) in the account and the cost to buy back the borrowed shares. Following our Facebook short selling example above, let’s examine the credit balance following changes in the price of FB.

 

FB Market Value

Margin Requirement or Equity

Credit Balance

Initial short

$36,000

$18,000

$54,000

Price Increase to $250/share

$50,000

$4,000

$54,000

Price decrease to $150/share

$30,000

$24,000

$54,000

The short seller is required to deposit additional margin in the account when the margin falls below the total margin requirement of $18,000. When the price of FB shares increases from $180 to $250, the market value of the shares increases by $14,000, which reduces the margin to $4,000 ($18,000 - $14,000). Also, the margin following the price increment now falls below the Reg T 50% requirement since $4,000/$50,000 = 8%. This is the basic principle of short selling - a short seller’s equity will fall when the stock price increases, and the equity will rise when prices decrease. Remember that short sellers hope that the stock’s price will drop so they can buy back the borrowed shares at the lower price to earn a profit. Looking at the table, you can see that a price decrease or increase did not change the value of the credit balance.