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Mechanics of a Short Sale

Lesson 4 of 6
Duration 3:51
Level Advanced
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An investor decides to sell a stock short in the hopes of being able to repurchase it at some later point in time at a lower price.

In order to make delivery of the stock, Investor A will need to actually have shares for delivery, so their broker will need to borrow stock from internal inventory or another broker. Brokers keep a list of available inventories on what is called a Box List. Brokers populate the Availability List through their own available clients, shares from other brokers, and from large institutions. Internal broker availability is derived from clients that purchase stock on margin and fully paid shares made available via the Stock Yield Enhancement Program.

Investor A, having found a source to borrow the shares , executes a short sale transaction on trade date, or “T” . Most major equity markets have a 2-day settlement period, i.e. the actual exchange of shares versus cash occurs on T+2, 2 business days after trade date. Settlement date is sometimes also referred to simply as “S”.

On the morning of Settlement Date or T+2, Investor A’s brokers Securities Lending Department

determines its actual delivery obligations for that day. They consult their own Availability List and if inventory is not available for internal borrowing, they consult the Availability Lists of other brokers.

Borrow transactions are arranged and the delivery of the shares from the lending broker to the

borrowing broker is affected if needed. These borrowed shares provide Investor A’s broker with the necessary inventory to deliver onward to settle the short sales .

It is important to understand that there will be situations where a given stock appears to be borrowable on T, but in the intervening 2 days, the availability changes such that on T+2, it is no longer borrowable.

This creates a situation in which the short sale trades will “fail”. In other words, the timely delivery obligation will not be met by the broker. In this case, a forced repurchase, or “close out” may be issued by the broker and the resulting trade will be charged to the Investor’s account, thereby reducing or eliminating the short position.

In exchange for Investor A selling the borrowed shares, the cash received from selling the shares is used as collateral on Investor A’s borrowed shares.

Investor A’s Broker invests the cash collateral and uses a portion of the interest to pay administration fees and stock borrowing fees. Because of steep administration costs, remaining interest is generally only paid out to large balance short sellers. In certain hard to borrow cases, borrowing fees are so high (greater than the interest earned) that the short seller needs to pay for the privilege of borrowing stocks.

Any dividend earned during the term of the stock borrow will be paid to the borrower (Investor B) who holds the borrowed shares. The Lender of the Shares (Investor C) will be paid an equivalent cash amount by the Short Seller (Investor A) in what is called Payment in Lieu of Dividends.

Please note short selling is generally considered a high-risk strategy and should only be undertaken by experienced investors who understand the potential risks involved.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.

Disclosure: Short Selling

Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account.

Disclosure: Displaying Symbols on Video

Any trading symbols displayed are for illustrative purposes only and are not intended to recommend a particular investment or investment strategy.

Disclosure: Margin Trading

Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment. Before trading, read the Disclosure of Risks of Margin Trading, available in the Forms and Disclosures section of your local Interactive Brokers website. For additional information regarding margin loan rates, see the Pricing section of your local Interactive Brokers website.

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