Short selling is the sale of a security that is not owned by the seller, usually one that the seller has borrowed. It's important to know that in the process, a short seller is required to make up for any benefits the long investor (stock owner) would receive if they had actually owned the stock.

Who Is the Shareholder of Record?

When you short a stock, you are borrowing the stock from an investor or broker, then selling those shares on the open market to a second investor. Even though you borrowed and sold the shares to another investor, the transaction between you and the lender is still listed on the books as if the lender is still long on the stock and you are short on the stock (even though that person no longer owns the stock).

Since that original investor who lent you the stock is no longer an actual shareholder, as the short seller, you are required to make up for any benefits the investor would have received had they actually still owned the stock.

What Short Sellers Are on the Hook For

In other words, if a company pays a dividend to shareholders, the second investor who bought the shares from the short seller would get the dividend check from the company. But because the original investor is no longer a shareholder of record (since the second investor owns those shares now), then the short seller must pay the dividend out of his or her own pocket.

Finally, when the short seller decides to close out the short position, he or she buys shares on the open market (from a third investor) and then gives the shares back to the original investor, who closes out the short position and puts everything back to square one.

(For further information on short selling, please see our Short Selling tutorial.)

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