A Short Look at Shorts

Margin Madness & Short Squeezes

When you designate an order as a short sale, you are borrowing the shares from your broker. Your broker sets up a margin account -- it's a credit that has to be repaid at some time, depending on the discretion of your brokerage firm. An initial investment of $2,000 is required to set up a margin account. With margin accounts, investors are required to deposit at least 50% of the stock price in the account.

If the stock you are shorting rises, the account is subject to a maintenance margin -- investors have to put more money into the account. The regulations governing margin accounts are a bit more stringent on short sales: For every 20% gain in the stock price, you have to funnel another 30% into the margin account.

While margin requirements vary at different brokerage firms, buying or shorting stocks on margin carries heavy risks for average investors.

When you close out a short sale, known as short-covering, you repurchase the shares and give them back to your broker. Covering your short position at a loss can get ugly during a short squeeze. A squeeze occurs when a stock that has been shorted by many investors rises. More and more short-sellers must buy shares to cover their short positions, putting greater upward pressure on the stock price.

You can short a stock for as long as you want, unless your broker demands you give back the stock that you borrowed, which doesn't happen often. When you return the shares to the broker, you have to pay any dividends the company hands out.

There also are some restrictions on short-selling that may discourage some investors from giving it a go. You can't short-sell stocks that are trading below $5. Also, the price at which you short a stock must be at the market price or higher -- thanks to the uptick rule, which was instituted to avert continuous short-selling during a market decline, as was witnessed in the 1929 crash. (Exchange-traded funds, or ETFs, however, are not subject to the uptick rule.)

Also a key note for individuals: Most short sales usually must be executed in round lots of 100 shares.