Short Sales - Mechanism

Mechanism

See also: Securities lending

Short selling stock consists of the following:

  • The speculator instructs the broker to sell the shares and the proceeds are credited to his broker's account at the firm upon which the firm can earn interest. Generally, the short seller does not earn interest on the short proceeds and cannot use or encumber the proceeds for another transaction.
  • Upon completion of the sale, the investor has 3 days (in the US) to borrow the shares. If required by law, the investor first ensures that cash or equity is on deposit with his brokerage firm as collateral for the initial short margin requirement. Some short sellers, mainly firms and hedge funds, participate in the practice of naked short selling, where the shorted shares are not borrowed or delivered.
  • The speculator may close the position by buying back the shares (called covering). If the price has dropped, he makes a profit. If the stock advanced, he takes a loss.
  • Finally, the speculator may return the shares to the lender or stay short indefinitely.
  • At any time, the lender may call for the return of his shares e.g. because he wants to sell them. The borrower must buy shares on the market and return them to the lender (or he must borrow the shares from elsewhere). When the broker completes this transaction automatically, it is called a 'buy-in'.

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