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Market Insights / Commentary

Reminders about margin, Part 3

By David Russell

Our previous post explained how traders can use margin to buy a stock or ETF. This time we’ll look at the mirror image: using margin to sell a stock or ETF.

Commonly known as “short selling,” the strategy isn’t suitable for all investors because it entails potentially significant risk. In fact it can be more dangerous than buying on margin because losses can be unlimited.

The term margin means you’re borrowing to take a position. When you buy on margin, you’re borrowing cash from the brokerage to buy more stock. When you sell on margin, you borrow actual shares of a company.

After all, the basic principle of trading is to buy low and sell high. We normally think about buying first, but it’s not always necessary. Say a customer thinks a stock is too high. He or she can sell it on margin now and buy it back at a lower price in the future. Sell high and buy low!

Here’s an example of how it might work:

Say a customer has $10,000 of cash in their margin account. Let’s say their initial margin requirement is the Federal Reserve’s legal minimum of 50 percent. (Remember it can vary according to customer and brokerage.)

The customer sees Company X at $100 a share, and thinks it will drop. He or she sells 200 shares at the market price. Their $10,000 of initial equity is 50 percent of the resulting $20,000 in short market value.

Short market value is essentially the value of what they owe. In this case, the “what” is 200 shares of Company X.

They make money when Company X declines. If it slides to $90, their short market value drops by $2,000. One day they owed $20,000. The next day, they owed $18,000.

The trader can buy 200 shares now to close the position, which is called “covering” their short. They’d essentially net a profit of $2,000, minus fees associated with borrowing the shares.

But, it doesn’t always result in profits. Say Company X rallies to $110 and their short market value rises from $20,000 to $22,000. If they closed the position they’d essentially lose $2,000 and have only $8,000 in their account when it’s all said and done.

Let’s take a look at maintenance margin requirements, which are slightly different for short positions than long ones. First, remember that the maintenance margin requirement is the equity percentage customers need to keep a position open. The Fed mandates 25 percent for long trades, but it’s 30 percent for shorts.

In the example of a losing trade above, with the stock rising to $110 and their equity dwindling to $8,000, their percentage would be 36 percent. (That’s $8,000 of equity / $22,000 of short market value.) Pretty close to the threshold but not there yet.

This time the line in the sand is actually $111.54. We know this because the formula says to divide the original account value by 1.3. Doing a little math, that means the customer must have $7,692 of equity. That, in turn represents a short market value of $22,308. Divide that by the 200 shares and you get a value of $111.54.

Over that level, and the trader faces a potential “margin call.” And don’t forget it can get worse than this if Company X keeps climbing. Not only might their entire equity get wiped out, but they might even have to pay extra money to cover losses. Not fun.

To add insult to injury, the customer has to cover any dividends a company pays. After all, someone else owns the shares and is entitled to that cash!

Bottom line: Using margin to sell stocks short can be profitable if the trader gets the direction right. But the practice also has real risks that need to be understood.

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