Margin In Selling Short With Examples

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.

Here is How to Calculate Margin When Trade in Stocks and Futures

In a long transaction, you borrow money to buy securities, which you are obligated to pay back. Similarly, in a short sale, you sell securities short by borrowing the securities from a broker, then selling them, with the proceeds deposited in your account. But eventually you’ll have to buy the securities back to return them to the lending broker, which is why the market value of the shorted securities is considered to be a debit to your account.

Equity is equal to the total value of cash and securities if all open positions are closed and all financial obligations are satisfied. So if you deposit $5,000 in an account, and borrow $5,000 to buy $10,000 worth of stock, then your equity is initially $5,000 minus transaction costs. Accruing margin interest will also decrease your equity. If the value of the stock declines to $8,000, then your equity is reduced to $3,000 minus costs, because now the stock is worth $8,000, but you are still obligated to pay your broker $5,000 plus interest for the loan, which is your debit balance. Hence, when using margin to borrow money to enter into a long position by buying stocks:

Equity = Account Value – Debit Balance

Long Margin  =

Equity ───────────── Value of Securities

When margin is used as a performance bond to short securities, then equity equals the amount on deposit minus the value of the shorted securities.

So if you sold short $10,000 worth of stock instead of buying stock with your deposit, then your equity will equal the $15,000 on deposit ($5,000 deposit + $10,000 from short sale) minus the value of the shorted security, which is initially the $10,000 that you sold it for. If the value of the stock rises to $12,000, then your equity is reduced by $2,000, because you’re obligated to buy the stock back, so if you closed your position right now, you would pay $12,000 to buy the stock back and have $3,000 left in your account (minus transaction costs and dividend payouts). Since shorted securities have to be bought back, the debit balance is equal to the current market value of the shorted securities.

Equity = Account Value – Value of Shorted Securities

Note that the account value will be decreased by transaction costs and by any dividends that have to be paid out while the stock is borrowed.

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.

Short Margin  =

Equity ──────────────────── Value of Shorted Securities

So the only difference in calculating the margin for a purchase and for a short sale is that the equity for a purchase is the account value minus the debit balance whereas for a short sale, the equity is the account value minus the value of the shorted securities. Both the debit balance and the value of the shorted securities are obligations that you eventually have to pay.

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 for a total account value of $15,000.


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, which means 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.

Remember that the above formulas and calculations have been simplified by excluding transaction costs, margin interest, and any dividends that have to be paid for shorted stock. These excluded factors reduce the equity in your account.

Margin Trading and Pyramiding

The main reason to borrow money to buy securities is for financial leverage. Financial leverage can increase the rate of return for an investment, if it is profitable, but it also increases potential losses. Because of the potential for greater losses, traders become more emotional in their trading decisions, which may cause excessive trading, which increases transaction costs, and it may cause bad trades when emotion overrules reason. Furthermore, the longer the money is borrowed, the greater the amount of margin interest that must be paid, so using margin for buy-and-hold strategies is generally not a good idea.

Another major disadvantage to using margin is that the trader potentially loses some control over the account. If purchased stock drops too much, the broker has the right to sell the stock before notifying the customer. For a short sale, the broker may be forced to buy back the securities in an illiquid market, if the lender wants the securities back.

If the margin ratio increases because purchased securities have increased in value or because shorted securities have decreased in value, then the trader gains excess margin that can be used to purchase or short additional securities. Continually using excess margin to increase investments is called pyramiding. 

While pyramiding may work for a while, at some point, the equity of the account is going to decline, because stocks don’t continually increase in value nor do shorted stocks continually decline in value. Therefore, eventually there will be a margin call. Hence, the use of margin should be restricted to short-term trades.

Margin Agreement, Initial and Maintenance Margin, Margin Calls, and Restricted Accounts

The most general definition of margin, one that covers both buying and shorting securities, is the ratio of the equity of the account divided by the value of the securities. The equity of the account is simply what is left when the debit balance is paid in full or the shorted stocks have been bought back and returned to the lender.

If money is borrowed, then it must be paid back, so the amount borrowed plus the accrued margin interest is a debit to the account; if stocks are sold short, then the shorted stocks must be bought back, so the value of the shorted stocks are a debit to the account.

Margin  =

Equity ───────────── Value of Securities

To use margin for trading, you have to open a margin account by signing a margin agreement. The agreement stipulates, among other things, the initial margin requirement as a percentage, and the margin maintenance percentage. Any securities bought in a margin account are held in the broker’s street name, and the margin agreement usually gives the broker the right to lend the securities out for a short sale.

Margin trading is governed by the Federal Reserve, and other self-regulatory organizations (SROs), such as the New York Stock Exchange and the NASD. Regulation T, promulgated by the Federal Reserve, requires that the minimum deposit be $2,000, and that the initial margin percentage be at least 50%.

There is also a minimum maintenance margin requirement of 25%. The exchanges or the brokerages can set stricter requirements than those required by the Federal Reserve if they choose. At most brokerages, the maintenance margin requirement is set higher, usually at 30%.

The margin ratio cannot be less than the maintenance margin rate. If the margin ratio falls below 50%, but remains above the maintenance margin requirement, then the account will be restricted. No additional securities can be bought or sold short in a restricted account, unless the trader deposits additional cash or securities to increase the margin level to at least 50%.

The amount of margin available will depend on the price of the securities. If margin is used to buy securities, then the amount of margin increases with the market value of the securities, but if the margin is used to short securities, then the amount of margin is inversely related to the price of the shorted securities, and vice versa.

If the equity does drop below the maintenance margin requirement, then the broker will issue a margin call, requesting that additional cash or securities be deposited so that the margin ratio of the account is equal to at least 50%. If you do not respond to the margin call, then your broker will sell enough of your securities that were purchased on margin and/or buy back your shorted securities at the market to bring your margin ratio back to the initial margin requirement of 50%.

Margin in Stock and Futures Trading

Margin is the use of borrowed funds in brokerage accounts to buy securities using them as collateral. Like any loan, the borrower must pay interest while the loan is outstanding, and must eventually pay the loan back.

The interest on the borrowed funds—margin interest—is slightly higher than the prime rate that banks charge to their best customers. To use margin, the customer must open a margin account with a broker, and the money is borrowed from the broker. The interest rate charged by the broker will depend on how much the broker pays its bank for the money—called the brokers rate—plus whatever amount the broker decides to add. Typically, brokers have a sliding scale of margin interest that depends on the size of the individual trading account, with larger accounts paying a lower interest rate than smaller accounts.

Margin can also refer to the minimum amount of equity required to insure the performance of an obligation. A common example is the margin needed to short stocks. To sell a stock short, you borrow the shares from a broker, then sell them in the market, with the hope of being able to buy the shares back at a lower price. The proceeds of the stock sale are placed in your brokerage account. Although you are not buying the stocks initially, you will still be required to have a minimum amount of equity in your account before you can short the stock to guarantee that you will be able to buy them back later, even if the price of the stock is higher than the shorted price. You do not have to pay interest nor do you earn any interest on the sale proceeds, because the money is not yours, but is held as security to buy the stock back later.

Similar to the margin requirement to short stocks, the term margin is also used in futures and forex accounts that specify the amount of cash or cash equivalents, such as U.S. Treasuries, that are required to guarantee the performance of the futures or currency contract. In futures, the margin requirement is frequently referred to as a performance bond, because it is not borrowed money, but is a deposit that guarantees the performance of the contract at the time of settlement. A trader pays no interest on the margin in a futures or forex account—in fact, traders can earn interest by depositing U.S. Treasuries in a futures account to cover the margin requirement.

In futures and forex, the margin requirement is often expressed as a leverage ratio, which is inversely related to the margin percentage:

Margin Percentage =

100 ─────────── Leverage Ratio

Example — Calculating the Margin Percentage from the Leverage Ratio

A 100:1 leverage ratio yields a margin percentage of 100/100 = 1%. A 200:1 ratio yields 100/200 = 0.5%. You'll often see these leverage ratios advertised by forex brokers. A 100:1 ratio allows you to buy $100,000 worth of currency while posting only a mere $1,000! Forex brokers can offer these low margin requirements because currency doesn't move with the same magnitude as stocks, especially in a short time, but the large leverage ratio does make currency trading very risky if all of the margin is used.

Leverage Ratio = 1/Margin Percentage = 100/Margin Percentage

Example — Calculating the Leverage Ratio from the Margin Percentage

Most stock brokers require at least a 50% initial margin, therefore:

Leverage Ratio = 1 / 0.5 = 2

In other words, you can buy twice as many stocks using maximum margin than you can without using margin. Your investment is leveraged for greater profits or greater losses.

Margin ratios are usually much smaller in futures than for stocks, where leverage ratios are typically 10:1, which is equal to a 10% initial margin requirement, but this varies depending on the underlying asset, and whether the trader is a hedger or a speculator—speculators have a slightly higher margin requirement. Forex accounts have an even lower margin requirement, which may vary, depending on the broker. Regular forex accounts typically allow 100:1 ratios, which corresponds to a 1% margin requirement, and the typical ratio for a forex mini-account is 200:1.

How To Buy Or Sell Stocks Using Execution Only And Discount Brokers?

An execution only stockbroker such as discount broker offers to only execute your orders at the market but without giving you an advice to buy or sell a specific stock. He buys and sells shares on the instructions of clients but who offers no advice about what to buy and sell. Self-directed investors who want to make their own decisions are most suited to this service, and will probably be attracted by the lower dealing costs. So you as an investor take all responsibility for investment decisions. You give the instructions to buy or sell a stock by telephone or online, on a stock brokerage website or by using their software. So discount brokers:

• Do business over the phone or on the Internet by using their web site or software

• Because of low overheads, such as support a research department or spending time with their clients, they can charge lower commissions.

• You will pay less than if you trade with a full service broker.

• Discount brokers also offer no-load mutual funds with no transaction fee.

• Deep discount brokers charge a minimum commission of at least $5 up to $15

It is important to make sure that you know all the charges upfront. Execution only brokers may also require a minimum level of activity for an account or they charge a minimum fee (inactivity fee). So it is important to now how many trades you will make a month or a year, and choose a broker based on that.

WHAT DO I NEED TO DO BEFORE I CAN BUY SOME STOCKS:

To be able to buy/sell stocks, you have to choose a brokerage and sign up with them. You have to decide what is the best brokerage to use for trading. Sometimes it is one with lowest commission, but sometimes there are other important factors such as: interest paid on unused balance of your money in your brokerage account, interest charged for used margin in trading, maintenance inactivity fees, friendly using trading platform, trading platform monthly fee, wire transfer in/out if you live outside of US etc.

Before you can start trading, you have to fund it first! To fund the trading account, most executing only (discount) brokerages allow funding via cheque, account transfer and bill payment from any online banking account or by wire transfer. After the account is open and funded, you will get a username and password to log in in to the trading platform or on a web site, and you will be able to buy or sell stocks in the supported markets.

HOW TO OPEN A BROKERAGE ACCOUNT

Opening a brokerage account is very similar to opening a bank account with some additional information required. There is also likely to be a minimum investment required which could be as low as $500 or $1,000 for cash account and $2,000 for a margin account. So you have several types of accounts to choose when opening an account:

• Single Account: Only one individual person is allowed to trade.

• Joint Account: Two individual persons can trade

• Cash Account: When you buy a stock (or ETFs) you have to pay 100% within a three days. This is the most common type of all accounts. If you don’t have the cash, you can buy the stocks.

• Margin Account: Using this type of account you can borrow money from your brokerage account to purchase a security, for which they charge interest. You have to put up a minimum of 50% or more, with a $2,000 minimum to open an account. Rules for margin accounts are set by FINRA (http://www.finra.org/index.htm). If the price of a security declines by a certain amount, generally by 30%, then the broker will ask you to come up with the cash immediately by selling other securities to make up the amount or cash. 

Margin accounts can be very dangerous, especially in a declining or volatile market. For example, SP500 index is the most secure instrument of all stocks, and has the lowest volatility compared to individual stocks which is also known as the "beta". If you bought it in October 2007, before crisis began, your highest loss at any moment would be at 02 Mart 2009 when SP500 fall from 1562 in October 2007 to 756. Percentage loss in index was around 53%! So, if you have used all margin available in your account, you would got a margin call, and all your positions would be sold. On the other hand, if you bought right stocks, and they had an advance in price of 50%, your profits would be 100% on your original investment because of your leverage. It all depends how leveraged is used.