7.2.1.2.2.1. The Price DeclinesLet’s examine what happens if there is a decline in the value of shorted stock bought on margin. Remember that a decline in value is good for a short seller.
Example: Candy shorted 1,000 shares of XYZ at $30 per share. Suppose XYZ then fell to $25 per share, causing the SMV of Candy’s stock to fall from $30,000 to $25,000 (1,000 × $25).
The credit balance stays the same because the proceeds and the deposit are unchanged. Equity, on the other hand, increases as the following equation shows:
credit balance
–
SMV
=
equity
$45,000
–
$25,000
=
$20,000
A special memorandum account is created for a short margin account when the value of the borrowed stock declines. This makes sense, because short sellers make money when the price of the security falls. The price drops as the short seller hopes, and the borrower’s equity goes up. The excess equity, equity above the required margin, is credited to the special memorandum account. SMA in a short margin account is equal to the amount over 50% of the short market value of the shorted security.
So back to Candy: Her reduced margin requirement has produced some excess equity.
50%
x
SMV
=
margin requirement
50%
x
$25,000
=
$12,500
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