Understanding the role of Regulation T of the Federal Reserve Board may help viewers better understand the concept of margin for short sellers. This video lesson neatly summarizes the key concepts and requirements facing investors wanting to sell short stocks at Interactive Brokers.
Introduction and Recap of Margin
Trading on margin is about managing risk. Imagine you want to buy a home. You have $50,000 in cash
and receive a loan of an additional $50,000 to buy a house for a total of $100,000.
Then, a year later, you sell the home for $250,000. After repaying the $50,000 loan, your initial $50,000
investment turned into $200,000. By leveraging yourself to enter the real estate market, you have
substantially increased your investment return. While you just enjoyed greater gains, you also risked
greater losses had the investment not worked in your favor.
The most commonly understood definition of trading on margin is borrowing cash to buy securities.
The concept of margin also ties into leverage. Leverage is what gives you the ability to increase your
buying power in the marketplace. By entering into a margin loan agreement with your broker, you gain
the ability to buy more stock than you would otherwise be able to with your own funds.
For more information about margin basics, enroll in our Margin Trading course in the Traders’ Academy
Short selling is governed by Regulation T of the Federal Reserve Board in order to manage the risk
associated with selling something that you do not own.
As the short seller, you are borrowing shares from another investor or a brokerage firm and selling it in
the market. This involves risk, because you are required to return the shares at some point in the future.
That requirement creates a liability or a debt for you.
It is possible for you to end up owing more money than you initially received in the short sale if the
market price of the shorted security increases after you sold it. If that happens, you may not be
financially able to buy back and return the shares to the investor from whom they were borrowed.
Therefore, margin requirements act as a form of collateral in requiring the short seller to put up equity
beyond the value of the short sale transaction.
A margin account also allows your brokerage firm to liquidate your position. This is part of the
agreement that is signed when the margin account is created and increases the likelihood that you will
return the shares before losses become too large and you become unable to return the shares.
A short sale transaction is like a mirror image of a long trade where margin is concerned.
Under Regulation T, short sales require a deposit equal to 150% of the value of the position at the time
the short is created. This 150% includes the full value of the short (100%), plus an additional margin
requirement of 50% or half the value of the position.
The margin requirement for a long position is also 50%.
If you short a stock and the position had a value of $20,000, you would be required to have the $20,000
that came from the short sale plus an additional $10,000, for a total of $30,000.
This is your initial margin requirement. Once the position is created you will be transitioned to your
maintenance margin requirement, the minimum amount in your account to ensure that there is
adequate margin to hold on to the short position.
Your maintenance level is based on the current market price of the security, and not on the initial price
at which the security was sold short.
The maintenance margin requirement on short sales depends on the price and quality of the stock, since
these determine the risk associated with the short position.
For example, blue chip stocks may have substantially lower maintenance margin requirements than
speculative small-cap stocks.
Margin requirements on a short sale can also be fulfilled with eligible securities in your account. In your
margin account, you can pledge these securities as collateral to meet the margin requirements of the
short sale, typically as an additional 50% of the value of the transaction.
These securities are pledged to the lender of the margin loan in your account. In this case, the lender
would be your broker.
The broker then uses the securities as a pledge for the margin on their own margin account or as
backing for a loan with a bank.
Again, it’s important to be aware of the risks. If you are unable to meet your loan obligations, your
broker has the right to liquidate your assets to settle the account.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.
Disclosure: Margin Trading
Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.
For additional information regarding margin loan rates, see ibkr.com/interest