How would a short sale really be handled by a brokerage in a practical sense under certain conditions (see details)?

Question

I understand what a short sale is, and I understand the risks, especially if you do it on margin. I also understand what your broker (brokerage account) might do pre-emptively if they anticipate your position is going to be, er, problematic.

But what I would like to know in a "real life, two friends talking, non-legal sort of way," is what is most likely to happen, using the following hypothetical example as a means to ask the question. I hope the "spirit" of the question is clear, and folks can respond accordingly.

Example: I have an account with a name-brand brokerage with cheap or free trades that I can do online, and the account at the moment has $25k in it, all cash, no positions held.

Let's say I want to short ACME (made-up, not to be confused with any actual company or symbol with that name, if there is one).

ACME trades for $100 per share, and I "sell" 50 shares, bringing the cash in the account from 25k to 30k.

Now, I feel confident that ACME will drop but maybe not immediately. Sure enough, ACME doesn't move very much and stays pretty close to 100 for two or three weeks and I do nothing.

In layman's terms, I would like to know what I would most likely see under the following cases:

Case 1: ACME continues to barely move for weeks, maybe months. If I do nothing, does my brokerage do anything? Am I paying them continually for "borrowing" the ACME? About how much, using the numbers in my example? Can this go on as long as I want?

Case 2: ACME starts to go up. Even if it doubles to 200, I can close my position for 10k, and I have 30k cash in the account. What will the brokerage do? Anything? Will the stock have to cost some percentage of my total account balance (or exceed it) before the brokerage forces an involuntary purchase to close my position? How long can this go on?

Thanks!

Answer 1

I understand what a short sale is, and I understand the risks...

I would argue you really don't, if you don't know when (at what price) to expect a margin call.

real life, two friends talking, non-legal sort of way

This topic is a routine matter for brokers. They will gladly explain their policies and you can expect they will follow them. For retail investors, there is not any unofficial way around the rules.

Case 1: ACME continues to barely move for weeks, maybe months. If I do nothing, does my brokerage do anything? Am I paying them continually for "borrowing" the ACME? About how much, using the numbers in my example? Can this go on as long as I want?

Yes, you pay a borrow fee, which is typically no more than a few percent per year. So, less than a dollar per day in your example. You would only have to close the position ("forced buy-in") if the owner of the shares you borrowed decides to sell them and there is such a shortage that no other ACME shares are available to borrow.

Case 2: ACME starts to go up. Even if it doubles to 200, I can close my position for 10k, and I have 30k cash in the account. What will the brokerage do? Anything? Will the stock have to cost some percentage of my total account balance (or exceed it) before the brokerage forces an involuntary purchase to close my position? How long can this go on?

The key concept you need to understand is margin requirement. In your example where the stock price doubles, your equity (net account value) is $20k while your debt is $10k, so indeed you still have plenty of margin. For a typical maintenance margin requirement of 25%, ACME would have to reach $480 before you would get a margin call (requiring you to deposit more money or close the position). At that point, your equity would be $6k versus debt of $24k.

Answer 2

Sell-to-open at $5000 and then buy-to-close at $10000 is a $5000 loss which results in an account balance of $20000 versus the starting balance of $25000.

Well, when the short position is opened the cash increases but the cost of closing the position is accounted against the cash for no overall change in account balance at that beginning moment. The amount of cash increase is the value that is borrowed.