Post by hundredtoone on Nov 25, 2007 10:12:25 GMT -5
Selling Short
Most investors make money by buying a security at a low price, then selling it later for a higher price. Owning a security is having a long position in that security. Selling short is a way to profit when the securities decline in price, by borrowing the securities, selling it, then hoping to be able to buy it back later at a lower price to replace the securities borrowed. However, if the securities pay a dividend or interest before the short is covered, then the short seller must pay those amounts to the lender of the securities.
In order to borrow the securities to sell short, the broker may lend out securities from the brokerage's own inventory, or from that of another brokerage, or he may lend out securities held in the margin accounts of other investors. If the broker is unable to borrow the securities, as sometimes happens with illiquid securities, for instance, then the security cannot be sold short.
A broker can lend out securities from the margin accounts of other investors, because the standard margin agreement allows it. When an investor opens a margin account at a brokerage, any securities bought for the account are held in the street name, the name of the brokerage for the beneficial interest of the investor and as collateral for any borrowing. The standard margin agreement allows the broker to lend out the securities held in its margin accounts to short sellers, and to be able to sell short, the investor must have a margin account.
Example¡ªProfits and Losses from Selling Short.
An investor borrows 100 shares of XYZ stock that is currently trading at $35 per share and pays a 4% dividend, and sells it. Assume that the stock paid a dividend of $1.40 per share before the short seller covered his short. This puts $3,500 in the short seller¡¯s margin account. $140 will eventually be deducted to pay for the dividend. If the price subsequently declines to $30, the investor can buy it back for $3,000 to return the borrowed shares, thus covering his short position, and netting $500 - $140 = $360 from the trade. If, however, the price of GM stock rises to $40, then the short seller will have to buy back the stock for $4,000, resulting in a net loss of $500 + $140 = $640. Brokerage commissions must also be subtracted from any profit or added to any loss.
Before 1998, many investors sold short stocks that they actually owned¡ªselling short against the box¡ªas a means to protect capital gains, or to convert a short-term gain into a long-term gain, which has a lower tax rate. However, this method has been rendered ineffective by the Taxpayer Relief Act of 1997. Any short sale against the box after June 8, 1997, is considered a constructive sale by the IRS, and is subject to a capital gains tax in the year of the sale.
A large investor may also sell short against the box to prevent the disclosure of ownership in the security.
Margin
Short sales can only be made from a margin account. Typically, a margin account allows the account holder to borrow up to 50% of the equity in the account for the purchase of new securities. There is also a maintenance requirement that is typically 30% of the equity. If the value of the equity drops below 30% of the total amount, then the broker issues a margin call. The investor either has to send more cash or other equity, or the broker will sell enough of the securities, to increase the total equity back to 50%. Thus, if the investor initially deposits $5,000 into a new margin account, he can buy up to $10,000 worth of stocks. If the value of those stocks subsequently declines to below $7,000, then the investor will be subject to a margin call, because $2,000 is what remains of the investor's equity, which is less than 30% of the total amount in the account. He will have to deposit another $1,500 to bring the equity to back to 50%.
Calculating the Percentage of Total Equity in a Margin Account
Total Equity % = Market Value - Borrowed Amount
©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤
Market Value If Total Equity % < 30%
then broker issues margin call.
The margin and the margin maintenance requirement are specified by Regulation T, enacted by the Federal Reserve Board. Currently Regulation T requires an initial deposit of $2,000 or more for a margin account, and, initially, 50% or more in cash or eligible securities as security for any borrowing to buy securities. As applied to a short sale, the investor must have at least 50% of the short-sale proceedings in equity. Note, however, that a broker may establish more stringent requirements.
In a short sale, money is deposited into the short seller's account, but this money is borrowed, because they are the proceeds of borrowed shares that were sold, and therefore, this money earns no interest for the account holder. Thus, instead of securities, the short seller has borrowed money in his account, which is subject to the same margin restrictions as buying stock. The amount of short sales proceeds doesn't change after the sale, but the price of the borrowed security does, and margin requirements are tied to the price of the shorted security, not the money in the account, because, [glow=red,2,300]eventually, the shorted securities will have to be bought to replace the borrowed shares. Therefore, the current margin of the account is dependent on the current market price of the shorted security because the short seller has a legal obligation to buy back and return the securities that were borrowed.[/glow]
However, calculating the margin is different, depending on whether the shorted security is below or above its shorted price.
Formula 1. Calculating the Current Margin of a Short Account if the
Current Market Value of Shorted Security < Short Sale Price
Current Margin = Equity
©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤
CMV Math Note: Multiply fraction by 100
to get a percentage.
CMV = Current Market Value
of Shorted Security
Formula 2. Calculating the Current Margin of a Short Account if the
Current Market Value of Shorted Security > Short Sale Price
Current Margin = TVA - CMV
©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤
CMV TVA = Total Value in Account
CMV = Current Market Value
of Shorted Security
Example¡ªCalculating the current margin and current equity of a short sale.
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account. There is now $15,000 in your account. However, you still only have $5,000 of equity in your account, because the $10,000 of short-sale proceeds is from borrowed securities.
Scenario 1 ¡ª The stock price declines to $6 per share, so the 1,000 shares that you sold short is currently worth $6,000. Using formula 1, above, current margin is then equal to 5,000/6,000 = 0.83 x 100 = 83%. Thus, this short sale would be profitable if you bought back the shares now to cover your short, for a net profit of $4,000.
Scenario 2 ¡ª The stock price rises to $11.75 per share, which means it will cost you $11,750 to buy back the shares now. Because the shorted security has risen above the shorted price, we use formula 2, above, to find that current margin = (15,000 - 11,750)/11,750 = 0.28 x 100 = 28%. Because your current margin is now less than 30%, you will be subjected to a margin call. If you decide to buy back the shares now to cover your short, your net loss will be $1,750, excluding brokerage commissions and any dividends that had to be paid.
By algebraically transforming Formula 2, we easily arrive at the equation for calculating the price of the shorted security that will trigger a margin call.
thismatter.com/money/Stocks/Selling-Short.htm
...Flying Moose(cmkxunofficial)
Most investors make money by buying a security at a low price, then selling it later for a higher price. Owning a security is having a long position in that security. Selling short is a way to profit when the securities decline in price, by borrowing the securities, selling it, then hoping to be able to buy it back later at a lower price to replace the securities borrowed. However, if the securities pay a dividend or interest before the short is covered, then the short seller must pay those amounts to the lender of the securities.
In order to borrow the securities to sell short, the broker may lend out securities from the brokerage's own inventory, or from that of another brokerage, or he may lend out securities held in the margin accounts of other investors. If the broker is unable to borrow the securities, as sometimes happens with illiquid securities, for instance, then the security cannot be sold short.
A broker can lend out securities from the margin accounts of other investors, because the standard margin agreement allows it. When an investor opens a margin account at a brokerage, any securities bought for the account are held in the street name, the name of the brokerage for the beneficial interest of the investor and as collateral for any borrowing. The standard margin agreement allows the broker to lend out the securities held in its margin accounts to short sellers, and to be able to sell short, the investor must have a margin account.
Example¡ªProfits and Losses from Selling Short.
An investor borrows 100 shares of XYZ stock that is currently trading at $35 per share and pays a 4% dividend, and sells it. Assume that the stock paid a dividend of $1.40 per share before the short seller covered his short. This puts $3,500 in the short seller¡¯s margin account. $140 will eventually be deducted to pay for the dividend. If the price subsequently declines to $30, the investor can buy it back for $3,000 to return the borrowed shares, thus covering his short position, and netting $500 - $140 = $360 from the trade. If, however, the price of GM stock rises to $40, then the short seller will have to buy back the stock for $4,000, resulting in a net loss of $500 + $140 = $640. Brokerage commissions must also be subtracted from any profit or added to any loss.
Before 1998, many investors sold short stocks that they actually owned¡ªselling short against the box¡ªas a means to protect capital gains, or to convert a short-term gain into a long-term gain, which has a lower tax rate. However, this method has been rendered ineffective by the Taxpayer Relief Act of 1997. Any short sale against the box after June 8, 1997, is considered a constructive sale by the IRS, and is subject to a capital gains tax in the year of the sale.
A large investor may also sell short against the box to prevent the disclosure of ownership in the security.
Margin
Short sales can only be made from a margin account. Typically, a margin account allows the account holder to borrow up to 50% of the equity in the account for the purchase of new securities. There is also a maintenance requirement that is typically 30% of the equity. If the value of the equity drops below 30% of the total amount, then the broker issues a margin call. The investor either has to send more cash or other equity, or the broker will sell enough of the securities, to increase the total equity back to 50%. Thus, if the investor initially deposits $5,000 into a new margin account, he can buy up to $10,000 worth of stocks. If the value of those stocks subsequently declines to below $7,000, then the investor will be subject to a margin call, because $2,000 is what remains of the investor's equity, which is less than 30% of the total amount in the account. He will have to deposit another $1,500 to bring the equity to back to 50%.
Calculating the Percentage of Total Equity in a Margin Account
Total Equity % = Market Value - Borrowed Amount
©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤
Market Value If Total Equity % < 30%
then broker issues margin call.
The margin and the margin maintenance requirement are specified by Regulation T, enacted by the Federal Reserve Board. Currently Regulation T requires an initial deposit of $2,000 or more for a margin account, and, initially, 50% or more in cash or eligible securities as security for any borrowing to buy securities. As applied to a short sale, the investor must have at least 50% of the short-sale proceedings in equity. Note, however, that a broker may establish more stringent requirements.
In a short sale, money is deposited into the short seller's account, but this money is borrowed, because they are the proceeds of borrowed shares that were sold, and therefore, this money earns no interest for the account holder. Thus, instead of securities, the short seller has borrowed money in his account, which is subject to the same margin restrictions as buying stock. The amount of short sales proceeds doesn't change after the sale, but the price of the borrowed security does, and margin requirements are tied to the price of the shorted security, not the money in the account, because, [glow=red,2,300]eventually, the shorted securities will have to be bought to replace the borrowed shares. Therefore, the current margin of the account is dependent on the current market price of the shorted security because the short seller has a legal obligation to buy back and return the securities that were borrowed.[/glow]
However, calculating the margin is different, depending on whether the shorted security is below or above its shorted price.
Formula 1. Calculating the Current Margin of a Short Account if the
Current Market Value of Shorted Security < Short Sale Price
Current Margin = Equity
©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤
CMV Math Note: Multiply fraction by 100
to get a percentage.
CMV = Current Market Value
of Shorted Security
Formula 2. Calculating the Current Margin of a Short Account if the
Current Market Value of Shorted Security > Short Sale Price
Current Margin = TVA - CMV
©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤©¤
CMV TVA = Total Value in Account
CMV = Current Market Value
of Shorted Security
Example¡ªCalculating the current margin and current equity of a short sale.
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account. There is now $15,000 in your account. However, you still only have $5,000 of equity in your account, because the $10,000 of short-sale proceeds is from borrowed securities.
Scenario 1 ¡ª The stock price declines to $6 per share, so the 1,000 shares that you sold short is currently worth $6,000. Using formula 1, above, current margin is then equal to 5,000/6,000 = 0.83 x 100 = 83%. Thus, this short sale would be profitable if you bought back the shares now to cover your short, for a net profit of $4,000.
Scenario 2 ¡ª The stock price rises to $11.75 per share, which means it will cost you $11,750 to buy back the shares now. Because the shorted security has risen above the shorted price, we use formula 2, above, to find that current margin = (15,000 - 11,750)/11,750 = 0.28 x 100 = 28%. Because your current margin is now less than 30%, you will be subjected to a margin call. If you decide to buy back the shares now to cover your short, your net loss will be $1,750, excluding brokerage commissions and any dividends that had to be paid.
By algebraically transforming Formula 2, we easily arrive at the equation for calculating the price of the shorted security that will trigger a margin call.
thismatter.com/money/Stocks/Selling-Short.htm
...Flying Moose(cmkxunofficial)
