During a short-sale transaction, shares are borrowed from a lender (usually the broker) by the short seller and sold in the market. The lender of these shares continues to maintain a long position in the underlying asset, while the short hopes to repurchase the shares and return them to the lender at a lower price.
- Short selling involves selling shares at current prices with the hopes of buying them back after the market has dropped.
- To do so, shorts must first borrow the shares to be sold, often from their broker.
- The lender charges the short margin interest on the loaned shares, which is paid by the short seller as a rebate to the origin owner.
- The harder it is to locate and borrow shares that are in relatively short supply, the higher these charges will be.
The Lenders of Short-Sale Shares
If the lender wants to sell the stock, the implications for the short seller will depend on where the shares were borrowed from—generally either from the brokerage firm's inventory or from the margin account of one of the firm's clients. Margin accounts differ from cash accounts in that they allow the firm to use shares held in these accounts in various ways. One use of margin accounts includes lending them for short sales activity.
When shorting, the seller borrows the shares to be sold. The lender then receives a rebate from the borrower of the shares, who pays a fee. This will vary in cost depending on the amount of shares currently available to short.
Using Shares Held by Other Clients
If the brokerage firm has taken the shares from its client's account, and that client wishes to sell the stock at some point while the short position is being held, the client can do so without a problem. This sale by the client who was lending shares will usually have no effect on the short seller, as the firm will either borrow the shares from another firm or use other shares in its own inventory.
For example, if investor A has 100 shares that are lent out to the short seller and they now wish to sell the shares, all investor A has to do is inform their brokerage firm of the desire to sell. The firm will then look in its inventory, and if there are 100 shares, the firm will sell them on the market and put the proceeds into investor A's account.
The brokerage firm will now be the one that is owed the shares by the short seller. However, the short seller could be at risk if the brokerage firm decides that it no longer wants to hold its position in the specific underlying stock. Perhaps the broker foresees some difficulty in the company and wants to divest themselves of the holding or it may be a result of balancing the brokerage's portfolio.
When the Broker Wants to Sell Loaned Shares
If the firm is unwilling to continue to lend shares to the short seller, it can require them to close their position. The brokerage firm has the right to call any short seller to return the shares at any point. In this case, the short seller will have to return the shares to the brokerage firm by purchasing them on the market, regardless of whether they end up incurring a loss or a profit based on the current market share price.
If you are the one whose shares are being lent out by your broker to a short seller, your part in the short sale transaction will have no effect on your ability to sell the shares. During the short sale, your shares are the ones currently being designated as lent out by the brokerage firm, but the broker essentially owes you shares. When you want to sell the shares, the broker is required to replace your shares so you may sell them on the market. In the age of electronic-based shares and transactions, all of this is done without your knowledge and has little effect on the average client.