Short Selling and Margin Buying
When it comes to investing, you can divide the whole pie into two pieces: long and short. Long investing means you're expecting the price of a security (usually a stock) to go up. Short investing means you're betting the market price of a security will go down. Most people go long, but risk lovers often go short, knowing that they may reap spectacular returns when a corporation falls.
Short selling is the practice of selling a stock (usually a borrowed stock) before you've bought it, and hoping the share price will drop so you can replace the borrowed shares with shares that cost less than the ones you sold. It sounds tricky because it is tricky, but an example with numbers will make it more clear.
When the stock market experiences a sudden, sharp decline, the government may put the kibosh on short selling. Since short investors want share prices to drop, their activity can actually cause further declines in an already falling market. To stop a market crash (and to boost investor confidence), short selling may be temporarily suspended until market equilibrium can be restored.
Let's say Joe thinks shares of Exxon will go down very soon, and he wants to profit from it. Joe borrows 100 shares of Exxon from his broker and sells them for the current market price of $100. That means Joe just brought in $10,000. But he still owes his broker 100 shares of Exxon. If he's lucky, Exxon shares will drop. If they do drop, let's say to $90 per share, Joe can pick up the 100 shares for just $9,000, scoring a quick $1,000 gain. (We're also assuming there are no transaction fees here, to keep the numbers simple.) If the price doesn't go down, Joe buys the shares at $100, hands them over to his broker and breaks even. But if Exxon rallies, and the shares climb to $101 per share, Joe's out of luck. Now he has to pay $10,100 for those same shares, netting an instant loss that comes directly out of his pocket, and directly out of his portfolio.
Margin buying is related in the sense that it involves borrowing, and can also cause devastating losses that deplete an investor's portfolio. The investor who buys on margin buys stock using a little of his own money and a lot of his brokerage firm's money. To buy on margin, you first have to have a margin account set up with your broker. Once you make a buy, the shares remain in the account as collateral on the loan. Sounds like a good deal, right? You get to buy more shares than you ever could on your own, and the shares themselves count as collateral for your loan.
If everything goes your way, and the stock price goes up, it is a great deal. But if the price drops, you're in a lot of hot water. Not only did you lose money on your investment, but you still owe the brokerage firm the money you borrowed to buy the stock, plus interest. Of course, the stock could rebound, but that doesn't fix the current situation. You see, to maintain a margin account, you're required by law to have what's called a maintenance margin. Federal law requires a maintenance margin of at least 25 percent; the balance of your margin account has to be equal to at least 25 percent of the value of the stocks you borrowed.
If there's anything an investor dreads, it's a margin call from his broker. Those come when a stock the investor has bought on margin drops in price. The shares in the margin account are no longer worth enough to cover the account's collateral requirements, and the investor has to scramble to make up the difference.
An example with numbers will clarify. Suppose Jane wants to buy $10,000 worth of shares in IBM and wants to use only $5,000 of her own money. She buys the shares through her margin account, using $5,000 of the broker's money, and the IBM shares are held in the account. The next week, IBM has dropped in value, and Jane's shares are only worth $7,000. The balance in her margin account has now fallen to $2,000 (the current share price of $7,000 less the $5,000 loan), which is $500 less than the 25 percent maintenance margin. Jane either has to pony up $500 (which she'll do if she thinks the shares will rebound) or sell the shares for a loss and pay off the loan.