How It Works

Suppose a company’s shares are selling for $50 each. After the short seller has looked at the business’s outlook or considered signs of a potential economic slowdown, their analysis indicates that the share price will fall. Based on that forecast, they sell 100 shares at $50 each, or $5,000 (minus fees to execute the transaction and cover borrowing costs). Another investor has a different view, believing the share price will rise. They want to lock in a price now through a purchase and then sell after the price climbs. They buy 100 shares at $50 each (plus brokerage commissions).

To conduct the transaction, the short seller obtains shares through a prime broker, who borrows the stock and then facilitates delivery on behalf of the short seller. The money from the short sale is held in the short seller’s escrow account until the short seller obtains shares to replace the shares their prime broker had borrowed on their behalf.

Should the share price fall to $25, the short seller stands to make $2,500 (minus transaction costs) — roughly the difference between what the buyer paid for the shares and what the short seller paid to obtain shares that “cover” the borrowed shares transferred by the broker-dealer to the buyer.

If the share price, however, rises to $75, the short seller will lose $2,500 (plus transaction costs) while the buyer will gain the same amount (commissions and fees will reduce the gain) if they still have the shares and want to sell at $75 a share.

An investor can “short” a stock if they have been told by their prime broker that:

The prime broker has borrowed the security or made a “good faith” arrangement to borrow the security; or,

The prime broker reasonably believes they can locate and borrow the security by the settlement day; and,

The prime broker has documented compliance with either of the above two requirements.(16)

Since mid-October 2008, the SEC requires participants of a registered clearing agency to deliver securities on a long or short sale in equities by settlement date (three days after the sale transaction action, T+3) and to promptly close out any failures to deliver. (This restriction is in place until July 31, 2009.) If a short sale violates this close out requirement, then any broker-dealer acting on the short seller’s behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer’s activity applies not only to short sales for the particular short seller, but to all short sales for any customer.(17)

Most of the time, an investor can hold a “short” for as long as they want. However, they may be forced to cover their position if the lender wants back the borrowed stock. Known as being “called away,” this practice is rarely done.

Engaging in short selling entails many risks and costs. One danger is the theoretical possibility of an unlimited loss. In comparison to a “long” purchase of shares, where you can only lose the amount of money you originally invested (plus fees), there is no maximum to the loss that a short seller could incur. In other words, there is no cap on how high a share price could go; the higher the share price, the greater the loss. Unexpected news may cause share prices to rise sharply, and short sellers’ demands for stocks to cover their positions may suddenly exceed the shares available, further pushing up share prices. (See sidebar box below on the “short squeeze.”) (18)

To conduct short sales, an investor must open a “margin” account.(19) They put in a percentage of the short selling proceeds with the prime broker lending them the remaining percentage. They’ll pay interest on the funds they’ve borrowed for the transaction. Regulatory collateral must be posted.

If and when dividends are paid, the borrower is responsible for paying those dividends to the person from whom the shares were borrowed. The prime broker also charges a fee for arranging the loan. (See the section on stock lending and dividend payments of borrowed securities on pages 8 – 9.) If losses in the margin account exceed a certain threshold, the prime broker will demand more cash or securities to meet its margin (collateral) requirements, or liquidate the position. The proceeds from the short seller’s initial sale of their prime broker’s borrowed shares are held in an escrow account until the short seller covers those shares.