Short sales can only be made from a margin account. Typically, a margin account allows the account holder to borrow up to 50% of the equity in the account for the purchase of new securities. There is also a maintenance requirement that is typically 30% of the equity. If the value of the equity drops below 30% of the total amount, then the broker issues a margin call. The investor either has to send more cash or other equity, or the broker will sell enough of the securities, to increase the total equity back to 50%. Thus, if the investor initially deposits $5,000 into a new margin account, he can buy up to $10,000 worth of stocks. If the value of those stocks subsequently declines to below $7,000, then the investor will be subject to a margin call, because $2,000 is what remains of the investor's equity, which is less than 30% of the total amount in the account. He will have to deposit another $1,500 to bring the equity to back to 50%.
The margin and the margin maintenance requirement are specified by Regulation T, enacted by the Federal Reserve Board. Currently Regulation T requires an initial deposit of $2,000 or more for a margin account, and, initially, 50% or more in cash or eligible securities as security for any borrowing to buy securities. As applied to a short sale, the investor must have at least 50% of the short-sale proceeds in equity. Brokers may establish more stringent requirements.
In a short sale, money is deposited into the short seller's account, but this money is borrowed, because they are the proceeds of borrowed shares that were sold, and therefore, this money earns no interest for the account holder. Thus, instead of securities, the short seller has borrowed money in his account, which is subject to the same margin restrictions as buying stock. The amount of short sales proceeds doesn't change after the sale, but the price of the borrowed security does, and margin requirements are tied to the price of the shorted security, not the money in the account, because, eventually, the shorted securities will have to be bought to replace the borrowed shares. Therefore, the current margin of the account is dependent on the current market price of the shorted security because the short seller has a legal obligation to buy back and return the securities that were borrowed.
The equity of a short account is equal to the amount on deposit minus the current value of the shorted security:
Equity = Account Value - Market Value of Shorted Security
The short seller also has an obligation to pay any dividends to the shareholder of the borrowed stocks. The broker pays this automatically from the short seller's account, which will decrease the amount on deposit, and therefore, the short seller's equity and margin.
Example — Calculating the Equity of a Short Account
If you deposit $5,000 and sell 1,000 shares of XYZ stock short for $10 per share, then there is $15,000 on deposit in your account, but your equity is still $15,000 - $10,000 = $5,000, which is, of course, what you initially deposited.
If XYZ price rises to $12 per share, then your equity = $15,000 - $12,000 = $3,000.
If XYZ price drops to $8 per share, then your equity = $15,000 - $8,000 = $7,000.
To calculate margin, just divide equity by the market value of the shorted security:
Calculating the Current Margin of a Short Account
Margin = Equity
─────
CMV
CMV = Current Market Value of Shorted Security
Math Note: Multiply fraction by 100 to get a percentage.
Example—Calculating the current margin and current equity of a short sale.
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account. There is now $15,000 in your account. However, you still only have $5,000 of equity in your account, because the $10,000 of short-sale proceeds is from borrowed securities.
Scenario 1 — The stock price declines to $6 per share, so the 1,000 shares that you sold short is currently worth $6,000. Thus:
your equity = $15,000 - $6,000 = $9,000
your margin = $9,000/$6,000 = 1.5 = 150%
Thus, this short sale would be profitable if you bought back the shares now to cover your short, for a net profit of $4,000 minus brokerage commissions and any dividends that had to be paid while the stock was borrowed.
Scenario 2 — The stock price rises to $12.00 per share, thus it will cost you $12,000 to buy back the shares now.
your equity = $15,000 - $12,000 = $3,000
your margin = $3,000/$12,000 = .25 = 25%
Because your current margin is now less than 30%, you will be subjected to a margin call. If you decide to buy back the shares now to cover your short, your net loss will be $2,000 plus brokerage commissions and any dividends that had to be paid while the stock was borrowed.
The margin and the margin maintenance requirement are specified by Regulation T, enacted by the Federal Reserve Board. Currently Regulation T requires an initial deposit of $2,000 or more for a margin account, and, initially, 50% or more in cash or eligible securities as security for any borrowing to buy securities. As applied to a short sale, the investor must have at least 50% of the short-sale proceeds in equity. Brokers may establish more stringent requirements.
In a short sale, money is deposited into the short seller's account, but this money is borrowed, because they are the proceeds of borrowed shares that were sold, and therefore, this money earns no interest for the account holder. Thus, instead of securities, the short seller has borrowed money in his account, which is subject to the same margin restrictions as buying stock. The amount of short sales proceeds doesn't change after the sale, but the price of the borrowed security does, and margin requirements are tied to the price of the shorted security, not the money in the account, because, eventually, the shorted securities will have to be bought to replace the borrowed shares. Therefore, the current margin of the account is dependent on the current market price of the shorted security because the short seller has a legal obligation to buy back and return the securities that were borrowed.
The equity of a short account is equal to the amount on deposit minus the current value of the shorted security:
Equity = Account Value - Market Value of Shorted Security
The short seller also has an obligation to pay any dividends to the shareholder of the borrowed stocks. The broker pays this automatically from the short seller's account, which will decrease the amount on deposit, and therefore, the short seller's equity and margin.
Example — Calculating the Equity of a Short Account
If you deposit $5,000 and sell 1,000 shares of XYZ stock short for $10 per share, then there is $15,000 on deposit in your account, but your equity is still $15,000 - $10,000 = $5,000, which is, of course, what you initially deposited.
If XYZ price rises to $12 per share, then your equity = $15,000 - $12,000 = $3,000.
If XYZ price drops to $8 per share, then your equity = $15,000 - $8,000 = $7,000.
To calculate margin, just divide equity by the market value of the shorted security:
Calculating the Current Margin of a Short Account
Margin = Equity
─────
CMV
CMV = Current Market Value of Shorted Security
Math Note: Multiply fraction by 100 to get a percentage.
Example—Calculating the current margin and current equity of a short sale.
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account. There is now $15,000 in your account. However, you still only have $5,000 of equity in your account, because the $10,000 of short-sale proceeds is from borrowed securities.
Scenario 1 — The stock price declines to $6 per share, so the 1,000 shares that you sold short is currently worth $6,000. Thus:
your equity = $15,000 - $6,000 = $9,000
your margin = $9,000/$6,000 = 1.5 = 150%
Thus, this short sale would be profitable if you bought back the shares now to cover your short, for a net profit of $4,000 minus brokerage commissions and any dividends that had to be paid while the stock was borrowed.
Scenario 2 — The stock price rises to $12.00 per share, thus it will cost you $12,000 to buy back the shares now.
your equity = $15,000 - $12,000 = $3,000
your margin = $3,000/$12,000 = .25 = 25%
Because your current margin is now less than 30%, you will be subjected to a margin call. If you decide to buy back the shares now to cover your short, your net loss will be $2,000 plus brokerage commissions and any dividends that had to be paid while the stock was borrowed.
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