Let’s say Trader Travis has identified Chic Chicanery Chain (obviously, a hypothetical stock) as an appropriate short-selling candidate whose accounting shenanigans are poised to catch up with it. Travis decides to short 1,000 shares of the company, currently trading at $50. Here are the steps involved in the short selling process:
- Travis places the short sale order through his online brokerage account or financial advisor. Travis must declare the short sale as such when entering the order, since an undeclared short sale amounts to a violation of securities laws. He would also need to ensure that he has a minimum of $25,000 (50% of $50 X 1000 shares) as initial margin in his margin account prior to making the short trade.
- Travis’s broker will attempt to borrow the shares from a number of sources – its own inventory, from the margin accounts of one of its clients, or from another broker. The Securities and Exchange Commission’s Regulation SHO, which went into effect in January 2005, imposes a “locate” requirement on a broker-dealer prior to making a short sale. This requires a broker-dealer to have reasonable grounds to believe that the security to be shorted can be borrowed, so that it can be delivered to the buyer on the date that delivery is due.
- Once the shares have been borrowed or “located” by the broker-dealer, they will be sold in the market and the proceeds deposited in Travis’s margin account.
Travis’s margin account now has $75,000 in it – $50,000 from the short sale of 1,000 shares of Chic Chicanery Chain at $50, plus $25,000 (50% of $50,000) as Travis’s margin deposit.
Assume that the broker’s maintenance margin requirement (MMR) is 30%; this should be interpreted as 130% (100% + 30%) of the current market value of the stock. Further assume that after a few days the stock is trading at $60. Since the MMR is 130% of the current market price of the shorted stock, the total margin requirement would now be $78,000 (130% x $60 x 1000 shares).
Travis had already contributed $25,000 as margin when the short sale was made, but the total margin requirement of $78,000 means that his account balance is deficient by $3,000 ($78,000 – $75,000). He will therefore receive a margin call from his broker demanding that the margin shortfall be rectified immediately. Travis will have to inject an additional $3,000 into the margin account right away to meet the maintenance margin requirement.
Note that Travis’s initial equity was $25,000 (when the stock was shorted at $50), but when the stock rises to $60, his equity drops to $15,000 (since he has a unrealized loss of $10,000 on the short position), necessitating the margin top-up in line with maintenance margin requirements
At what price of the shorted security would a margin call be triggered? This can be calculated as follows: Margin Account Value / (1+ MMR). Thus, based on the margin account value of $75,000 when the short trade was initiated, a margin call would be triggered if the market value of the shorted security rises above $57,692 ($75,000 / 1.30), assuming an MMR of 30%, which equates to a stock price of approximately $57.69 ($57,692 / 1000 shares). If the MMR was 40%, then a margin call would be triggered if the stock rose above $53.57.
If Travis cannot meet the maintenance margin requirement, the broker can (and usually will) close out his short position at the current market price. If this price is $60, Travis will be left with a loss of $10,000 ([$50 – $60] x 1000 shares) on his short position.
Assume that after two weeks, the stock declines to $45. Travis decides to close out the short position by buying back the 1,000 shares that were sold short, at a total cost of $45,000. Therefore, his gross profit (before costs and commissions) would be $5,000 ([$50 – $45] x 1000 shares).
On the other hand, suppose the company decides to clean up its act, as a result of which the stock spikes to $70, at which price Travis decides to close out his short position rather than run the risk of mounting losses. In this case his loss would be $20,000 ([$50- $70] x 1000 shares).