What is a Rebate?
A rebate is the portion of interest or dividends earned by the owner (lender) of a stock that is paid by a short seller (borrower) of the stock. The borrower is required to pay interest and dividends to the owner. Short selling requires a margin account.
Basics of a Rebate
Rebate is a term used in short-selling, which is selling securities that a trader does not own. In order to sell a stock that isn't owned, the trader must borrow the stock in order to deliver it to the buyer.
When an investor places a short sale trade, that individual must deliver the stock to the buyer on the trade settlement date. The goal of selling short is to profit from a price decline by buying the stock at a lower price after the sale. Selling short exposes the seller to unlimited risk since the price of the shares that must be purchased can increase by an unlimited amount. That said, a trader can exit a short sale at any time to cap the risk.
If dividends are paid during the period that the stock is borrowed, the borrower must pay the dividends to the lender. If bonds are sold short, any bond interest paid on the borrowed bond must be forwarded to the lender. Shorting a stock involves paying interest or a fee, and in some cases, the broker may forward some of that fee to the stock lender.
It is difficult for individual traders or retail investors to qualify for a rebate as it requires the holding of substantial sums in their trading accounts. Generally large institutions, market-makers, and traders with broker/dealer status are beneficiaries of rebates.
Short Sale Rebate Fee
When a short seller borrows shares to make delivery to the buyer, the seller must pay a rebate fee. This fee depends on the dollar amount of the sale and the availability of the shares in the marketplace. If the shares are difficult or expensive to borrow, the rebate fee will be higher. In some instances, the brokerage firm will force the short seller to buy the securities in the market before the settlement date, which is referred to as a forced buy-in. A brokerage firm may require a forced buy-in if it believes that the shares will not be available on the settlement date.
Before going short, a trader should check with their broker what the short sale rebate fee is for that stock. If the fee is too high, it may not be worth shorting the stock.
How Margin Accounts Are Used in Short Stock Rebates
The Federal Reserve Board’s Regulation T requires that all short sale trades must be placed in a margin account. A margin account requires the investor to deposit 150% of the value of the short sale trade. If, for example, an investor’s short sale totals $10,000, the required deposit is $15,000.
Since short sellers are exposed to unlimited losses, a substantial deposit is required to protect the brokerage firm from potential losses in a customer’s account. If the price of the security increases, the short seller will be asked to deposit additional dollars to protect against larger losses. If the price continues to rise on a position, causing a larger loss, and the borrower is unable to deposit more capital, the short position will be liquidated. The borrower is liable for all losses, even if those losses are greater than the capital in the account.
For example, assume a trader shorts 100 shares at $50. They are short $5,000 worth of stock, and are therefore required to maintain a balance of 50% more than that, or $7,500. If the stock drops, there is no problem since the short-seller is making money. But if the stock rises rapidly, the trader could face significant losses and may be required to put more money in the account. If the stock gaps up overnight to $80 per share, and the trader is unable to get out before that, it will cost them $8,000 to get out of that position. They will need to increase their account capital to $12,000 to keep the trade open, or they can exit the trade and realize the loss. If they take the loss, it is -$30 per share, multiplied by 100 shares, which is -$3,000. This will be deducted from the $7,500 balance, leaving them with only $4,500, less fees.
- Rebates are the portion of interest and dividends that the borrower of stock in a short sale pays to the investor who loaned her the stock.
- Rebates require margin accounts, whose balance is calculated on a daily basis based on the stock's price movements.
Example of Rebate
Suppose a trader borrows $10,000 worth of stock ABC with the intention of shorting it. She has agreed to a 5% simple interest rate on the trade settlement date. This means that her account balance should be $10,500 by the time the trade is settled. The trader is responsible for transferring $500 to the investor, or the person she borrowed the shares from to make the trade, on the trade settlement date.