Why Do You Need a Margin Account to Short Sell Stocks?
Richard Montana | August 25, 2022
Since the 18th century, stock trading has been a prominent part of the global economy. It has seen the rise and fall of many institutions, with many other commodities gaining prominence and otherwise through the system. As a modern-day investor, it is common knowledge that stock trading and investing are some of the most fantastic ways to make money. The real question is not usually about whether you can make money from it, but through which of the myriad of available ways you want to do it. One that we would be pitching to you today is short selling as a form of margin trading, and it is one to remember. What is short selling? How does it work? And why do you need a margin account to short sell stocks?
Short selling is a hazardous yet rewarding margin trading technique involving “borrowing” stocks from third-party brokerages, selling them off immediately, and repurchasing when the price pumps, after which the loan is repaid. In this scenario, a trader determines that a company’s stocks are overpriced and might undergo an adjustment or retracement soon. From there, they can choose to enter the market with capital nonexistent compared to the value of the stock trade they choose to open. Subsequently, subtracting the selling price as at when you sold it from the price you repurchased gives the profit or loss margin. To visualize, we can imagine Mr A is a stocks trader that believes DropIt Inc.’s stocks are overvalued. He borrows 100 shares of stock from Mr B, a broker with the company, at $2 per share. A sells the shares at market price for $200, after which DropIt’s stocks dump to $1 per share. He repurchases the 100 shares at $100 and returns them to B, after which he pockets the remaining $100 as his profit.
While this process looks pretty clear-cut and straightforward, it is an incredibly risky venture that expert traders should only undertake. Apart from having the requisite knowledge of fundamental and technical analyses to determine overvalued stocks, it is also essential to possess trading experience and risk management discipline. This is because the $100 profit could have been a $100 loss with the wrong calculations. Moreover, entering a margin trade with borrowed assets means that there is also the potential for unlimited losses and debt. So that begs the question, “How and why are stocks borrowed for short selling?”
Why You Need a Margin Account
The answer to the preceding question is pretty simple; a margin account. A margin account is a distinct trading account designed to enable investors to execute trades with assets they do not ordinarily have. If you want to go by simpler terms, it is a stock loan account. It has already been established that short-selling stocks mean selling off assets that are not normally yours, hence the need to borrow them. Margin accounts exist specifically for that, making them the only kind of account that supports short-selling financial assets. This is so because it possesses three main features useful for margin trading, namely;
- Margin: Margin is the total of the funds or assets an investor has to deposit with the brokerage that they are borrowing from to offset part of the credit risk they are taking on. It typically functions as some sort of collateral, which is to be expected from a “loan account”. It is, in a practical sense, the collateral for the loan you borrow from the brokerage in margin trading and is leveraged to determine how the amount you would be borrowed to execute your trade.
- Liquidation: During the creation of the margin account, several factors are taken into consideration, including its liquidation. This is a feature incorporated in margin trading to assist the brokerage in safeguarding the assets in your account. It gives them the right to terminate your trade when it approaches the price where they feel your losses would be getting too much to pay back. That way, they can prevent you from continuing to accrue even more debt and increasing their own risk of not recovering it.
- Regulation-T: This is the legal stipulation by the Federal Reserve Board that mandates margin traders, including short sellers, to operate a margin account with the brokerage they are borrowing from. It also ensures that investors cannot borrow more than 50% of the total value of shares in a trade, which ordinarily keeps you from dangerously exceeding your margin trading borrowing threshold.
In a nutshell, the key takeaways from our short encounter here demonstrate the fact that you can only use a margin account to short sell as an investor. This is because it is the only kind of account that is used for margin trading as it; provides for you to borrow in a way as to enable short selling and is designed to protect both you and your brokerage. And frankly, the most compelling of reasons is that the law has it set in stone. So as an investor interested in short selling, you definitely want to get very familiar with a margin account for all intents and purposes.