Part 05

Part-05
Margin Trading
&
Short Sales
1
Copyright Tarheel Consultancy Services
Introduction
2
Margin Trading - A Definition
 ‘Buying stock on margin’ connotes:

 Acquisition of stock by an investor, by
borrowing a part of the required funds from
a broker
 It is a partly debt financed purchase of
shares+ =
Own Debt Shares
money
3
Why Margin Trading?
 Obviously when you can purchase
shares using borrowed money you can
acquire more shares than what your
funds alone will permit.
4
Margin Account
 To indulge in margin trading

 need to set up a separate Margin Account
with the broker
 cannot be undertaken using a normal / cash
account
5
Minimum Margin
 In the U.S. law requires an initial
investment of minimum $2000 on the
part of the trader in order to operate a
margin account.
 In practice some brokers may demand even
higher amounts.
6
Regulation T
7
Securities Exchange Act 1934
 It gave powers to the Board of

Governors of the Federal Reserve
System the authority to regulate the
extension of credit against the pledging
of securities as collateral.
 Margin trading came to be regulated
under Regulation T, commonly known
as Reg T Copyright Tarheel Consultancy Services
8
Regulation T
 Established the maximum amount of
credit that may be extended by a
broker/dealer to facilitate purchases by
a client.
 Originally it permitted margin trading
only on exchange listed stocks.
 In 1985 authorization was given to Nasdaq
National Market stocks.
 Other OTC stocks may be traded on
margin: Copyright Tarheel Consultancy Services
9
Regulation T (Cont…)
 Stocks which do not qualify for margin

and options contracts must be paid for
in full.
 Mutual funds must be fully paid for
when acquired
 But can be used as collateral for loans taken
to buy stocks
10
Regulation T (Cont…)
 Debt instruments are generally exempt

from the provisions of Reg T.
 They are however subjected to industry
imposed rules and regulations.
 Convertible bonds are however subject to
Reg T.
 In 1985 Reg T provisions were extended to
certain categories of junk bonds.
11
Regulation T & Cash Accounts
 Regulation T lays down conditions not
just for margin trading but for trading in
cash accounts as well.
12
Cash Accounts
If full payment is If full payment is not
made made
A customer may buy The broker is required to
any security in a cash immediately cancel the
account transaction
The broker will sell the
securities
The customer will be liable
for any losses that the
broker may suffer in the
process
The customer’s account will
then be blocked or frozen
for 90 days
13
Frozen?
 If an account is frozen
 it does not mean that a customer cannot
trade during the 90 day period.
 customer can continue trading provided
subsequent trades are paid for in advance.
14
Free Riding
 A similar 90 day freeze is applicable if a
security is sold before the payment is
received.
 Assume that a T+5 settlement cycle is in
place.
Day T Day
Customer sells the
Stock is
T+5
Payment
security without
purchase having first paid for needs to
d it - Account will be be made
frozen for 90 days
15
Free Riding (Cont…)
 However if the payment is received

subsequently before day T+5, then the
freeze will be lifted immediately.
 The practice of buying and then selling
a security without paying for the prior
purchase is called free riding
 Reg T is an attempt to prevent free riding.
16
Reg T (Cont…)
 When a customer makes a margin

purchase or a short sale he must
deposit funds within 3 business days
from the date of the trade.
 As per regulations he must deposit a
minimum of 50% of the purchase price or
the short sale proceeds.
 Deposits over and above the minimum
required are permissible. 17
Reg T (Cont…)
 Margin requirements may be met by

 depositing cash
 depositing fully paid up securities
 Failure to deposit the required amount
within the stipulated time will lead to
the account being frozen.
18
Terminology
19
Terminology
 Margin Rate
 It is the percentage of the market value of
the securities that has to be deposited by
the customer.
 Loan Value
 It is the difference between the current
market value of the securities and the
amount that has to be deposited by the
customer.
 It also represents the maximum amount
20
Terminology (Cont…)
 Loan Rate
 It is the Loan Value expressed as a
function of the market value.
 Loan Rate + Margin Rate = 100%
 Broker’s Loan
 Actual amount that is borrowed from the
broker.
21
 Debit Balance
 Another term for the amount that is
borrowed from the broker.
 It signifies that the investor owes that
much to the broker.
 Credit Balance
 Sometimes instead of borrowing money a
client may have surplus funds in his
account with his broker.
 This balance will be called a Credit
Balance signifying that the broker owes
him the amount. 22
 Owner’s Equity
 (Market value of the securities) – (Debit
Balance)
 It is what the investor is entitled to if the
position is liquidated.

If the account were to have a credit
balance then the owner’s equity will be the
market value of the securities plus the
credit balance.
23
Reg T - Illustration
24
Illustration
 A client wants to purchase 100 shares

of IBM stock.
 The shares are trading at $100 each.
 The margin rate is 60%.
 The client wants to invest the minimum
amount as permitted by law.
25
Illustration (Cont…)
 Market Value = 100 shares x $100 =
$10,000
 Margin Rate = 60%
 $6,000 has to be deposited by the investor
 A maximum amount of $4000 can be
borrowed from the broker
 Loan Value = $4,000
 Loan rate = 40%
 Assume that the investor deposits
$6,000
 Owner’s Equity = $6,000 26
 Assume that the price rises to $130
 Market Value
 100 shares x $130 = $13,000
 Debit Balance will continue to be $4000
 13,000 – 4,000 = $9,000
27
 As per Reg T, minimum required

owner’s equity
 0.60 x 13,000 = $7,800
 New Loan Value
 13,000 – 7,800 = $5,200
 The Excess
 It is the difference between the Loan Value
and the Debit Balance.
 5,200 – 4000 = $1,200
28
The Excess
 Case 1: The excess can be withdrawn
by the investor
 Case 2: Else it can be used to acquire
more securities
29
Case 1: The Excess is Withdrawn
 If the client withdraws $ 1200

 Owner’s Equity: 9,000 – 1,200 = 7,800
 Debit Balance: 4000 + 1200 = 5,200
 This is consistent with the stipulation

that a maximum of 40% of the value of
the securities can be borrowed
30
Case 2: Additional Securities are
Bought
 If the excess is used to buy more

securities then
 1200 / 0.60 = 2,000 worth of securities can
be bought
 Market Value
 13,000 + 2000 = 15,000
 Debit Balance
 $4,000 + $2,000 = $6,000
 The entire $2,000 is borrowed from the
broker. Copyright Tarheel Consultancy Services 31
Case 2…(Cont…)
 $9000 = 60% of the Market Value
 This is consistent with the regulations
32
Buying Power
 The excess of $1200 is equivalent to an

ability to buy $2000 worth of securities.
 This is called the Buying Power
Excess Equity
Buying Power = ____________
Margin Rate
33
Reg T – Margin Call
 As per Reg T
 a margin call will be issued when a client
first buys securities on the margin.

i.e. he must deposit at least 50% of the value
of the securities as per current regulations.
 Subsequently due to an erosion in the value

of the securities, additional margin may be
called for.
34
Reg T (Cont…)
A margin call will be i.e. he must deposit at
issued when a client first least 50% of the value
buys securities on the of the securities as per
margin current regulations
Subsequently due to an These subsequent

erosion in the value of margin calls are made
the securities, additional by self-regulatory
margin may be called for organizations like the
NYSE or the NASD.
They are not mandated
 As per Federal Regulations, only one margin call is
by law
required, which is at the outset of the transaction.
 This call is called a FED CALL 35
Another Illustration
(More Perspectives)
 Take an investor called Michael

 He has $10,000 at his disposal
 He wants to buy shares of IBM
 IBM shares are trading at $100 each
 The margin rate is 50%
36
Trade
 Cash trade
 He could purchase 100 shares with $10,000
 Margin trade
 He could borrow an additional $10,000 and
purchase securities worth $ 20,000
 Thus he can buy 200 stocks
37
Leverage
 Advantage of margin trading

 It allows the investor to obtain Leverage
 What is leverage?
 Ability to magnify the return on invested
capital using borrowed funds to partly
finance the purchase of the asset.
38
Leverage (Cont…)
 Leverage is a double edged sword.
Advantage Disadvantage
Positive returns get Negative returns get

magnified magnified
If the market goes up, If the market crashes

percentage profits get percentage losses get
inflated inflated
39
Magnification of Returns - Cash
 Assume that Michael trades on a cash basis
 He can buy 100 shares using $10,000
 Assume that the shares are sold a week later
Case A Case B
Price at time of sale = Price at time of sale =
$125 $80
The 100 shares are The 100 shares are
worth $12,500 worth $8,000

The rate of return is: The rate of return is:
(12,500 – 10,000) / (8,000 – 10,000) /
10,000 = 0.25 10,000 = -0.20
≡ 25% ≡ -20%
40
Magnification of Returns -
Margin
 Assume that Michael chooses to trade

on the margin
 We will assume that he borrows the
maximum possible amount which is
$10,000
 With $20,000 he can buy 200 shares.
41
Magnification…(Cont…)
Case A Case B
Price at time of sale = Price at time of sale =
$125 $80
The 200 shares are The 200 shares are
worth $25,000 worth $16,000

$10000 has to be $10000 has to be
returned to the broker returned to the broker

Michael will be left Michael will be left
with $15,000 with $6,000

(15,000 – 10,000) / (6,000 – 10,000) /
10,000 = 0.50 10,000 = -0.40
≡ 50% ≡ -40%
42
Magnification…(Cont…)
 Margin trading doubles the rate of
return.
 Unfortunately this is true for losses as well.
DOUBL
E
43
Interest and Commissions
44
Interest & Commissions
 In practice the broker will demand

interest on the amount that he is
lending.
 This will:
 Reduce the percentage of profit, if there is a
profit
 Magnify the percentage of loss, if there is a
45
loss Copyright Tarheel Consultancy Services
Borrowing arrangement
The customer signs a In other words he
margin or hypothecation pledges or
agreement hypothecates the
securities as collateral
for the loan
The broker will re-
hypothecate the
securities to a bank as
collateral
The rate charged
by the bank is
In return he will get what called the broker
is called a Call or Broker call money rate. It
loan is usually 1% less
than the prime rate
Copyright Tarheel Consultancy Services (the rate at which46a
Call Loans
 The word `Call’ connotes that these

loans can be terminated or called on
demand by the lender.
 The loans are considered to be fairly
safe:
 They are collateralized by readily
marketable securities
47
Call Loans (Cont…)
 The broker will usually add a mark up of

at least ½ % to the call money rate
before extending a loan to a client.
 The lowest rates go to the largest
borrowers.
 In practice, small borrowers, with debit
balances of $10,000 or less could pay
as much as 2% more by way of interest.
48
 Customers have some ability to

negotiate rates.
 Large brokerage firms have rate
schedules that list rates as a function of
the size of the loan.
 In addition to the loan size the volume
of activity in the account is also
considered when the broker quotes an
interest rate.
49
 A customer with a smaller but more

active account may be able to negotiate
a better rate
 The additional income generated by way of
commissions will more than compensate the
broker for the concession made by way of a
lower interest rate.
50
 Interest paid on a margin account is tax
deductible to the extent that it is offset
by investment income in the form of
dividends, interest, and capital gains.
51
Illustration – Interest…
 Assume that the broker charges Michael
8% interest per annum on the amount
borrowed
 Assume that the account is kept open
for 3 months
52
Illustration… (Cont…)
Case A Case B
Price at time of sale = Price at time of sale = $80
$125 The 200 shares are worth

The 200 shares are worth $16,000
$25,000 $10000 has to be
$10,000 has to be returned to the broker by

returned to the broker by way of principal
way of principal $200 has to be paid by
$200 has to be paid by way of interest
way of interest Michael will be left with
Michael will be left with $5,800

$14,800
(14,800 – 10,000) / 10,000 (5,800 – 10,000) / 10,000
= 0.48 = -0.42
≡ 48% ≡ -42%
53
Interest…(Cont…)
 Case A: Compared to the case with no

interest, the rate of return has declined
by 2%
 Case B: Compared to the earlier case
the percentage loss has increased by
2%
 Thus interest charges
 Mitigate profits
 Magnify losses
54
Commissions (Cont…)
 Commissions too have an impact on the

rate of return.
 Assume that the broker charges a
commission of 10c per share
 The total charge for 100 shares will be
$10
 Assume that no interest is payable
 This way we can exclusively focus on
commissions.
55
Case A – Cash A/c Case A – Margin A/c
 Stock price = $125 Stock price = $125
The investor will pay an He would have bought 200
additional $10 to acquire shares by paying $20.
100 shares. Initial outflow = 10020
Initial outflow = 10010
He will pay $10 while The cash inflow at the end

liquidating the shares. = 25000 – 10000 – 20 =
Final inflow = 14980
12500 – 10 = 12490
(12,490 – 10,010) / 10,010 (14,980 – 10,020) / 10,020
= 0.2478 = 0.4950
56
≡ 24.78% ≡ Services
Copyright Tarheel Consultancy 49.50%
 In either case the profit percentage is
reduced because of commissions.
57
Case B – Cash A/c Case B – Margin A/c
 Stock price = $80 Stock price = $80
The investor will pay an He would have bought 200
additional $10 to acquire shares by paying $20.
100 shares. Initial outflow = 10020
Initial outflow = 10010
He will pay $10 while Final inflow =
liquidating the shares. 8,000 – 2,020 = 5,980

Final inflow =
8,000 – 10 = 7,990
(7,990 – 10,010) / 10,010 (5,980 – 10,020) / 10,020
= - 0.2018 = 0.4032
58
≡ -20.18% ≡ Services
Copyright Tarheel Consultancy 40.32%
Special Memorandum Account
59
Owner’s Equity
 The owner’s stake or owner’s equity is:

 Difference between the market value of the
securities and the amount that is borrowed
from the broker.
 i.e. (Market Value) – (Borrowed Amount) =
Owner’s Equity
60
Owner’s Equity
 In the case of Michael

 Purchased 200 shares at $100 each
 Borrowed 50% from the broker
 Market Value = 20,000
 Debit Balance = 10,000
 Owner’s equity = 10,000
61
T-Account - 1
 In a T-account format the account
position can be depicted as follows.
Liabilities Assets
Broker’s Loan = 10,000 200 shares @ $100 = $20,000
Owner’s Equity = 10,000
62
T-Account - 2
 Assume that the share price rises to
$125.
Liabilities Assets
63
Investor’s Choices
1. He can liquidate his position

 Receive a gross profit of $5,000 before
interest payments & commissions
2. He can use his paper profits without

liquidating his position
 This would require him to use a Special
Memorandum Account (SMA)
64
SMA
 This is an auxiliary account provided for
using the paper profits
 Reg T allows such an account to be
used as a temporary parking place for
the equity that is in excess of the
current requirements.
65
Excess
 Market value = $25,000

 Owner’s equity = $15,000
 The minimum requirement as per Reg T
is $12,500
 Excess = $2,500
 This will be credited to an SMA
66
SMA (Cont…)
 The SMA is a memorandum account.

 A credit balance in it merely signifies
the availability of excess equity.
 A credit to the SMA will not lead to a
reduction of owner’s equity in the main
T-Account.
67
SMA (Cont…)
 The investor may if he chooses

withdraw the balance in his SMA.
 If so, the broker’s loan will increase by
$2500 and the equity will decline by
$2,500.
 The T-Account will look as follows.
68
T-Account - 3
Liabilities Assets
69
SMA (Cont…)
 Investor can use balance in the SMA to
buy more shares of IBM (or any other
marginable security)
 Since the margin rate is 50%, the
buying power of $2500 is $5000
 If he does so:
 The market value of securities will increase
by $5,000
 The broker’s loan will increase by $5,000
70
T-Account - 4
 The T-Account will look as follows.
Liabilities Assets
71
SMA (Cont…)
 The excess equity is calculated on a

daily basis by the margin department of
the brokerage firm.
 It is based on the previous day’s closing
price
 An account without excess equity is called a
Restricted Account
72
SMA (Cont…)
 Now let us examine the consequences
of a market decline.
73
Borrowing arrangement
If the account becomes

under-margined, it may
receive a notice for
additional margin from
the broker
If the investor does not

comply, the broker may
sell off all or a part of the
securities
74
SMA (Cont…)
 These requirements for additional

collateral are imposed by the securities
industry
 They are not mandated by law
 As per Reg T a margin call is issued only
once – at the time a position is set up.
 Once the FED Call is met it is not issued
again.
75
Illustration - SMA
 Assume that the price has risen to $125

 The SMA has been credited with $2500
 The investor has fully utilized the SMA
balance to acquire 40 more shares
 Now assume that the price declines to
$110.
76
T-Account - 5
Liabilities Assets
77
SMA (Cont…)
 Equity of $11400  <50% of $26,400
 Despite this, as per Federal law no call
for fresh margin need be issued

 In practice a broker may do so - that is his
personal decision.
78
SMA (Cont…)
 We will now illustrate another feature of

the SMA.
 Assume that
 Share price has risen to $125
 $2500 has been credited to the SMA
 The customer neither withdraws the amount
in the SMA nor does he use it to acquire
additional shares.
79
SMA (Cont…)
 Assume that the share price declines to

$80
 The owner’s equity in the margin
account will obviously decline
 But the credit balance in the SMA will
not be affected.
 The client will still have a line of credit
equal to this amount.
80
T-Account - 6
Liabilities Assets
81
T-Account - 7
 The investor can withdraw the balance in the
SMA.
 If so, the main account will look as follows.
Liabilities Assets
82
T-Account - 8
 Else he can use the amount to buy shares
worth $5000.
 If so the main account will look as follows.
Liabilities Assets
Broker’s Loan = 15,000 262.5 shares @ $80 = $21,000
83
SMA (Cont…)
 In either case the SMA will be debited

by $2500.
 If the account were to lose its excess
equity due to a subsequent decline in
the share price the balance in the
SMA will not vanish.
84
SMA (Cont…)
 Stocks held in margin account that go

up in value  it creates SMA
 If stocks subsequently decline in value
 it does not lead to a reduction in the
SMA
 Thus once money is credited to an SMA,
it is not affected by any further adverse
market activity.
85
SMA (Cont…)
 While SMA balances can increase due to

favourable market movements  they
can decline only if used by the investor
 For example in T-Account - 6
 The owner’s equity is only 37.5% of the
market value of the shares but the SMA
continues to have a credit balance of $2500.
86
Sales in a Margin Account
 When a margin trader partially

liquidates his position by selling shares:
 50% of the sale proceeds will automatically
be released to the SMA.
 This amount can once again either be
withdrawn or else used to acquire additional
shares.
87
Illustration
 Michael is holding 240 shares of IBM @
$125 each
 The debit balance = $15,000
 The owner’s equity = $15,000
 Assume that the share price declines to
$100 & he sells 40 shares
 The market value of assets will decline
by $4,000
 This amount will be used to reduce the
loan from the broker
88
T-Account - 9
Liabilities Assets
89
Sales…(Cont…)
 Equity is now $9,000  <50% of the

market value
 But the SMA will show a credit balance
of $2,000
 This is because of the stipulation that 50%
of the sale proceeds should go to the SMA.
90
Maintenance Margin
91
Introduction
 NYSE & NASD insist that customers ought
to demonstrate a minimum level of
financial ability before being allowed to
trade on margin.
 Investors have to deposit $2,000 in cash or
fully paid up securities before availing of a
margin loan.
 Objective  to discourage leveraged
speculation by investors who are unable
to appreciate/afford the inherent risks.
 The exchanges have imposed a 92
Maintenance Margin
 It is a threshold level of the

shareholder’s equity
 If due to adverse price movements the
equity in the account were to hit or dip
below the specified maintenance
margin level, the customer will get a
Margin Call
93
Margin Calls
 It is an instruction to replenish the

equity to take the account balance to a
safer level
 If an investor fails to respond to a
margin call the broker may choose to
close out the position
94
Maintenance Margins (Cont…)
 Objective of ‘maintenance margin’  to
protect the broker’s investment.
 Helps ensure that the collateral is adequate
to cover the loan.
 For long stock positions  the
maintenance margin requirement is
25% of the market value of the
securities.
 As per Reg T the initial margin must be
at least 50% of the value of the
securities.
95
 So in practice things must go really wrong
Illustration of a Margin Call
 Steven has bought 200 shares of IBM @

$120 each by borrowing $12,000
 The issue is, how low should the share
price fall before a margin call is
triggered off
 If we denote this price by P:
200P – 12000
____________ = 0.25 ⇒ P = 80
96
T-Account - 10
Liabilities Assets
97
Maintenance Margin (Cont…)
 If the stock price goes below $80, a call

will be issued:
 The customer has to deposit more funds or
securities in order to raise the equity to a
higher level.
 It is a standard industry practice to
impose a higher requirement than that
specified by the NYSE / NASD
98
 In practice, thresholds of 30%-35% are
common.
 Higher levels give a greater cushion to the
broker - since prices can decline rapidly
 Higher requirements give the broker the
flexibility to waive the policy when required.
99
Waive Margin - Example
A historically credit His equity level may hit

worthy client may be 29% at a time when
going through a bad the required
patch maintenance margin is
35%
The broker may waive

the margin call in such a
case giving the client an
opportunity to be bailed
out by the market
100
 Margin calls must be met ‘on demand’

 As per standard margin agreements a
broker can sell stock from a margin account
without notice.
 In a period of rapid decline this could very
well happen.
 In normal times the brokers will give the
client 1-2 days to comply but not much
longer
101
Account Concentration
 A margin account is said to be

concentrated in a security if
 A sharp and adverse price change has the
potential to wipe out a client’s equity and
put the brokerage firm at a risk of loss.
Preferred margin a/c Non-preferred margin

Margin accounts with a/c with
Margin accounts
positions in a positions in a single
diversified pool of security or a small group
securities of securities
102
Concentration…(Cont…)
 Thus by putting restrictions on

concentration the brokers indirectly
encourage portfolio diversification.
 The rules regarding concentration vary
from broker to broker.
103
Typical Rules
 An account is said to be concentrated
if:
a. It contains a long security which if valued
at zero would create a deficit equity
position for the entire account
b. It contains a position > 50% of the daily
volume in the security
c. No account holder may hold 1 ¾ % + of
the outstanding shares of any company on
margin
d. All firm accounts collectively may not hold
7 ½% + of the outstanding shares of any104
Non - Eligibility
 Margin trading in not permitted in the

case of
a. accounts held in the name of minors.
b. most estate accounts – or accounts held in

the name of deceased persons
c. accounts held in a fiduciary capacity -

unless the trustee is specifically authorized
by the beneficiary.
105
Eligibility (Cont…)
 As per Reg T only certain securities are

eligible for margin trading.
a. All listed securities traded on organized
stock exchanges
b. OTC securities declared eligible for trading
on the National Market System.
c. OTC securities listed in:
 The Federal Reserve list of marginable OTC
stocks
 The list of foreign margin stocks
106
Short Selling
107
Introduction
 What will an investor do if he is bullish

about the market, or in other words
expects the market to rise?
 He will buy stocks in the anticipation of
being able to sell them subsequently at a
higher price.
 The principle behind taking such long
positions is: `Buy Low and Sell High’ 108
Short Selling
 Short sellers are people who expect the
markets to fall.
 They are bearish about the market
 They will seek to ‘Sell high and buy low’
109
Short Selling process
Investor sells before

a stock he does which…
not own
He has to borrow
the stock from broker
before
to be able to sell which…
Investor has to Broker has to

‘cover short get rights & obtain
position’ stock from
somewhere
110
Short Selling (Cont…)
 What does short selling involve?

 It requires the investor to sell a stock that
he does not own
 How can one sell something that he
does not possess?
 Obviously he has to borrow from someone
and sell.
 In practice he will borrow from a broker.
111
 Where will the broker get the shares
from?
a. May lend shares from his inventory
b. Give shares which are being held in a
margin account by another client
c. May borrow from an institutional client
d. May borrow from another broker
 When placing order broker must
clearly specify whether
 he is liquidating a long position
 he is establishing a Services
Copyright Tarheel Consultancy short position 112
 A broker obtains the right to borrow
securities from a client by appropriately
wording the margin agreement
 Such an agreement is known as a customer
loan consent
113
Short Selling – Threshold price
 A broker will allow only securities

trading above a threshold price level to
be bought on margin
 The floor is usually $5-$7 per share.
 Reason for very low priced stocks a
relatively small price change can
substantially wipe out the owner’s equity
 Stocks trading below these price levels will
usually not be available when an investor
seeks to borrow for the purpose of short
selling. Copyright Tarheel Consultancy Services 114
 A short sale order is not effective with a

broker unless he has received an
authorization from his stock loan
department signifying that the stock is
available.
 The availability position can change
from day to day.
115
Short Selling – Day Orders
 Short sale orders may be placed only as

Day Orders
 They are valid only for the day on which
they are placed
 If order remains unexecuted, at the end of
the day it would automatically stand
canceled.
 Customers who want the orders to stay
116
alive must once
Copyright again
Tarheel Consultancy place them the
Services
Covering Short Position
 When a share is borrowed and sold, the

proceeds will be credited to the
investor’s account.
 At some point in time the shares will
have to be purchased and returned to
the broker.
 This is called Covering The Short
117
 Most of the time the short position can

be kept open as long as the investor
desires.
 However the lender may at times seek to
call away the stock.
 At this point:
 Broker may borrow fresh shares on the
investor’s behalf
 Broker will request him to cover his position.
118
Short Sale - Dividends
 The investor/broker who lends the
shares to the short seller merely lends
the shares
 He does not sell them
 Any dividends declared during the
period of the short sale belong to the
investor/broker
119
 Dividends
 Will go to the party who buys the shares
from the short seller.
 Short seller must pay an amount equal to
the dividend to the lender of shares
 n:1 split during the period of the short
sale
 Short seller must return n shares for every
share that was borrowed.
 Right to vote
 Lender of short sales loses his right to vote
 This right will go to the party who buys the
share from the short seller 120
 Short selling is also a form of margin

trading
 Instead of borrowing cash the short seller is
borrowing shares from the broker
 Rules similar to those for margin trading
apply to short selling as well
 In order to monitor and track short sales
most brokerage firms execute and hold
such transactions in a short account 121
Short Accounts
 Short accounts are usually sub accounts

of margin accounts.
 An investor who is short selling must
make the same Reg T deposit that
would be required if the stock were to
be acquired on the margin.
 This deposit plus the sale proceeds
would show up as a Credit Balance in
the account.
122
Illustration
 Natalie decides to sell short 100 shares

of IBM.
 The current price is $100 per share.
 The market value of the securities is
$10000.
 She will have to deposit the sale
proceeds plus $5000 in her account as
123
per Reg T.Copyright Tarheel Consultancy Services
T-Account - 11
Liabilities Assets
100 shares @ $100 = 10,000 Credit Balance = $15,000
124
 Now assume that the value of the

shares drops to $80.
 The position will now have an equity of
$7,000.
 As per Reg T the required margin is
$4,000.
 So the excess equity of $3,000 will be
credited to an SMA.
125
T-Account - 12
 The balance in the SMA can either be
withdrawn or used for additional shorting.
 First let us see the position if the balance is
withdrawn.
Liabilities Assets
126
T-Account - 13
 Or the excess of $3000 can be used to short
additional shares worth $6000
 If so, 75 more shares can be shorted.
Liabilities Assets
127
Credit Balances
 Credit balance in a short account
provides collateral for the shares
which have been sold short.
 They are not Free Credit Balances
 They cannot be withdrawn
 Short seller will not earn any interest
on these balances.
 Interest on such balances will accrue to
the brokerage firm.
 Hence stock loan departments of
brokerage firms are usually very 128
Maintenance of a Short Position
 Short positions are inherently more

risky than long positions.
 When a security is bought on margin
the maximum possible loss is equal to
the purchase price of the security.
 In practice the investor’s loss will be
somewhat less than the full purchase
price of the stock.
129
Maintenance of a Short Position
When an investor buys on
margin the broker will tolerate
losses till the maintenance
level is reached
At this point a margin call will

be issued
If the investor does not

respond the stock will be
liquidated
The broker will collect his

dues and refund the balance
130
Maintenance (Cont…)
 A short position is more risky.

 What has been lent is a share and not
money
 Stocks have a maximum downside
potential due to limited liability.
 But there is no limit on the upside.
 A short seller has to buy the stock when
he covers his position.
 Hence hisCopyright
maximum potential loss is
Tarheel Consultancy Services
131
 Thus the self-regulatory agencies have
set the maintenance margin level for
stocks at 30% to reflect the greater risk.
132
Illustration
 How do we find the trigger

corresponding to the 30% threshold?
 Assume that Natalie has sold 100
shares of IBM @ $130
 She has deposited an initial margin of
$6500.
 Let the price corresponding to the 30%
level be denoted by P.
133
 Therefore:
19500 – 100P
___________ = 0.30
100P
⇒ P = 150.00
134
Shorting Against the Box
135
Shorting Against the Box
 A client who has a long position, decides
to sell short
 He has no intention of delivering the
security that he is holding
 Despite the fact that he has a long position
he will borrow and deliver.
136
Why?
 Traders typically go in for such a
strategy in order to
 defer unrealized capital gains for tax
purposes
 and continuing to protect the magnitude of
the capital gain
137
Illustration
 Assume that we are in 15 December

20XX.
 Assume that we had purchased a stock
in March of the year for $1,000 and that
the stock is currently worth $1,500
 An immediate sale would yield a capital
gain of $500
 Assume tax rate @ 30%
 Hence Tax = $150
138
 The client may want to defer the sale by

a year since he is anticipating a loss
from elsewhere, which can be set off
against this gain.
 But if he waits for a year the share price
could decline.
 This would lead to a reduced capital gain or
even a capital loss.
139
 Can the investor protect the capital gain

and defer the sale at the same time?
 The answer is YES
 By engaging in a short sale
 If he goes in for a short sale, any
change in the value of the long position
would be exactly offset by an equal and
opposite change in the value of the
140
 The net result would be a freeze on the

capital gain of $500
 For instance assume that the price after
6 months is $1800
 The gain on the long position would be $800
 The loss on the short position would be
$300
 The overall gain will remain at $500
141
Shorting Against the Box (Cont…)
 When an investor shorts against the box

he must post the usual margin
 The transaction must be approved by
the broker’s stock loan department.
 i.e. just because he is long in a security it
does not mean that he automatically has
the freedom to short.
142
The Uptick Rule
 The SEC, NYSE & NASD have specified
rules that prohibit short selling unless
the sale is at a price that is higher than
the last different price
 i.e. the trade must be on an uptick or a
zero uptick
 This is to prevent short sales in a falling
market
 Sustained short selling under such
conditions can cause markets to crash.
143
Risk
 Stock prices generally drift upwards

over the medium to long term.
 Even if the performance of the company
were to remain stagnant, the share price
should rise to compensate the owners for
the effects of inflation
144
Risk (Cont…)
1. Short selling amounts to betting

against the overall direction of the
market.
2. Short sales entail finite profits and
infinite losses
 Due to limited liability the lowest possible
stock price is zero.
 So the maximum possible gain is 100%
 But there is no limit on the maximum stock
price
145
Short Squeezes
 If a stock starts to rise and a large
number of short sellers attempt to
cover their positions at the same time,
it can cause prices to soar upwards
rapidly.
 This is Short Squeeze.
 What can cause these situations?
a. News in the market can trigger such a
squeeze.
b. Traders who notice a high short interest
may attempt to trigger a squeeze. 146
Economic Role
 Many analysts hold short sales to be a

major cause of market downturns.
 But such sales contribute positively to
the functioning of free markets.
a. They provide liquidity
b. They help drive down the prices of over
valued stocks to realistic levels.
147

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Part-05

 ‘Buying stock on margin’ connotes:

 Obviously when you can purchase

shares using borrowed money you can

acquire more shares than what your

funds alone will permit.

 To indulge in margin trading

with the broker

 cannot be undertaken using a normal / cash

 In the U.S. law requires an initial

investment of minimum $2000 on the

part of the trader in order to operate a

 It gave powers to the Board of

 Stocks which do not qualify for margin

 Debt instruments are generally exempt

 Regulation T lays down conditions not

just for margin trading but for trading in

cash accounts as well.

trade during the 90 day period.

 customer can continue trading provided

subsequent trades are paid for in advance.

 However if the payment is received

 When a customer makes a margin

 Margin requirements may be met by

 A client wants to purchase 100 shares

 Assume that the price rises to $130

 Debit Balance will continue to be $4000

 As per Reg T, minimum required

 Case 1: The excess can be withdrawn

 Case 2: Else it can be used to acquire

 If the client withdraws $ 1200

 This is consistent with the stipulation

 If the excess is used to buy more

 This is consistent with the regulations

 The excess of $1200 is equivalent to an

 Subsequently due to an erosion in the value

Subsequently due to an These subsequent

 Take an investor called Michael

 Advantage of margin trading

 Leverage is a double edged sword.

Positive returns get Negative returns get

If the market goes up, If the market crashes

worth $12,500 worth $8,000

 Assume that Michael chooses to trade

worth $25,000 worth $16,000

returned to the broker returned to the broker

with $15,000 with $6,000

 Margin trading doubles the rate of

 Unfortunately this is true for losses as well.

 In practice the broker will demand

 The word `Call’ connotes that these

 The broker will usually add a mark up of

 Customers have some ability to

 A customer with a smaller but more

 Interest paid on a margin account is tax

deductible to the extent that it is offset

by investment income in the form of

dividends, interest, and capital gains.

 Assume that the broker charges Michael

8% interest per annum on the amount

 Assume that the account is kept open

$125 The 200 shares are worth

$10,000 has to be returned to the broker by