Calculate leverage, equity and margin call prices for long and short positions.
In a margin account the broker lends part of the purchase price, secured by the securities. Initial margin is the minimum equity you must put up. Maintenance margin is the minimum equity ratio you must keep.
Equity = market value of securities minus loan. Equity ratio = equity / market value.
You buy $10,000 of stock with $5,000 of your own money and a $5,000 loan.
| Share price move | Market value | Loan | Equity | Equity ratio | Return on your $5,000 |
|---|---|---|---|---|---|
| +20% | 12,000 | 5,000 | 7,000 | 58.3% | +40% |
| 0% | 10,000 | 5,000 | 5,000 | 50.0% | 0% |
| -20% | 8,000 | 5,000 | 3,000 | 37.5% | -40% |
| -40% | 6,000 | 5,000 | 1,000 | 16.7% | -80% |
Leverage of 2 to 1 doubles gains and losses, before interest on the loan.
With a maintenance requirement m, a call occurs when market value falls below loan / (1 minus m). With m = 25%: 5,000 / 0.75 = $6,667, a fall of 33.3%. With m = 30%: $7,143, a fall of 28.6%. On a call you must deposit cash or securities or sell. The broker can sell your holdings without notice and you owe any shortfall.
A short seller borrows shares, sells them, and later buys them back to return to the lender, profiting if the price falls.
Example: short 100 shares at $50. The account is credited with the $5,000 proceeds and you post 50% margin of $2,500, for a credit balance of $7,500.
A borrowing fee that can be very high for scarce shares; payment of any dividends to the lender; margin interest; potentially unlimited loss because a price has no ceiling; recall of the borrowed shares; and the short squeeze, where a rising price forces short sellers to buy, pushing the price higher still, as with GameStop in January 2021.
In the US, Regulation SHO requires a broker to locate shares before a short sale and restricts short selling at or below the best bid for the rest of the day and the next day when a stock has fallen 10% in a day. In both countries short orders must be marked as short, and naked short selling (selling without arranging to borrow) is restricted.
Short interest is the number of shares sold short. Days to cover = short interest / average daily volume. A high figure means crowded positioning and squeeze risk.
It adds liquidity, lets investors hedge, improves price discovery and has exposed frauds that regulators and auditors missed.
You buy $10,000 of stock with $5,000 of your own money and $5,000 borrowed at 8%. Interest is $400 a year.
| Stock return over the year | Gain on the position | After interest | Return on your $5,000 |
|---|---|---|---|
| +20% | +2,000 | +1,600 | +32% |
| +5% | +500 | +100 | +2% |
| 0% | 0 | -400 | -8% |
| -20% | -2,000 | -2,400 | -48% |
Leverage helps only when the investment earns more than the interest rate. A 5% gain, which would have been a 5% return without margin, becomes 2% with it.
A trader shorts $200,000 of a stock that is hard to borrow, with a borrowing fee of 15% a year. The fee alone costs $30,000 a year, or $2,500 a month. The stock must fall 15% a year just for the trader to break even, before dividends paid to the lender. Fees on the most crowded shorts have at times exceeded 50% or 100% a year.
The lender of borrowed shares can recall them at any time. If the broker cannot find other shares to borrow, the short seller is forced to buy them back, often at the worst moment, during a squeeze.
In Canada, CIRO publishes short position reports for listed securities twice a month. In the US, short interest is published twice a month, and the SEC has adopted further reporting by large short sellers with a delayed start date. Short interest and days to cover are public signals of crowded positioning.
Borrowing on margin is not permitted inside a TFSA, RRSP or other registered account, and short selling is not allowed in them. In the US, IRAs can use only limited margin features. Leverage is a feature of taxable accounts.
Some brokers offer qualified clients 'portfolio margin', which sets requirements based on the risk of the whole portfolio, including hedges, rather than fixed percentages per position. It can allow much higher leverage, which is why eligibility is restricted.
Build a margin calculator: inputs for position value, loan, maintenance requirement and interest rate. Output the equity ratio, the price fall that triggers a call, and the return on equity after one year of interest for share price changes from minus 40% to +40%.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.