Several points that are unique to short selling should be understood by an investor before he begins any short selling activity in his portfolio.


A conventional sale of securities involves two parties, the buyer and the seller. In a short sale, a third party, the security lender, becomes involved. The ability to sell a security short is always contingent on the srt seller's ability to borrow the security through his broker. The borrowed security is then delivered to the buyer (or contra-party) on settlement date. Since a short sale involves the usual first two parties to a transaction, a buyer and a seller, it follows that the buyer of the security will demand delivery on settlement date.

Where does the brokerage firm get the securities to loan to the short seller? The securities loaned can be obtained from several sources. The most common source is other customers that are long the security in their margin accounts. The second most common source is the firm's own inventory, third is securities borrowed from another brokerage firm, and forth is securities borrowed from institutional investors.

A broker-dealer obtains the right to borrow securities from one customer and lend them to another in either the margin agreement, or much less frequently by wording in the account agreement itself. This authorization to borrow and loan securities is known as the customer loan consent, and it allows the brokerage firm to loan out only a portion of the customer's securities.

Since the primary source of loaned securities is other clients that own the same security long in margin accounts, and since most brokerage firms require a stock to be trading above a given price level to be margined (typically $5 to $7 per share), it follows that stocks that trade at prices below the threshold for margining at a give brokerage firm will be difficult or impossible to borrow. For example, if your brokerage firm only allows securities trading above $5 per share to be held on margin, you will most likely encounter a problem borrowing a stock trading at $3 1/2 for a short sale.

Regardless of where the borrowed securities are obtained, the lender always reserves the right to demand that the securities be returned upon demand at any time.

Thus, one risk of short selling occurs when the lender demands the loaned security be returned immediately, and other securities cannot be borrowed for a substitution. Since the short-seller has no control over this timing, he might have to buy the security at a higher price (thus a loss) in order to deliver it back to the lender. While this forced unfortunate timing could ruin an otherwise successful trading strategy, fortunately it is not a common problem.

Borrowing stock on large, widely held issues is usually not a problem. On issues with a small float (number of shares outstanding), or issues that have suffered from negative media coverage recently, borrowing securities becomes difficult or impossible. If your brokerage firm cannot come up with the security from it's own internal accounts and you are still interested in selling the security short, instruct your broker to have his stock loan department "shop the street" for availability.

Remember that short sale orders are never effective with a broker until he has received authorization from his stock loan department that the stock is available to borrow. Since the availability of a security can change from day to day, short sale orders are typically accepted as day orders only, and a short sale order that does not execute on a given day must be re-placed by the customer on subsequent days.

What happens if the stock pays a dividend while the short position remains open? Remember who still actually owns the stock? The lender (owner), who is still entitled to almost all the benefits that accrue to any other owner, including stock and cash dividends, rights offerings and spin-offs.

The only right that a lender of stock loses is the right to vote. This is true because a short sale creates two long positions, the "real" long position which goes to the buyer of the stock sold short when delivery is made, and a "phantom" long position that is held by the person loaning the stock to the short seller. Since the lender always holds cash collateral for the entire market value of his stock, he has in essence turned his certificate into cash while still retaining ownership. For as long as the stock remains on loan, the cash can be invested in some interest bearing instrument, thus bringing in extra income to the lender and providing the incentive to loan stock to a short seller.

When any dividend is paid by the corporation whose shares are held short, the investor holding an open short position must pay the amount of the dividend to the lender of the stock.

When the short security splits two-for-one, the borrower owes the lender twice as many shares, although theoretically at half the price per share. When a rights offering is made, the borrower must go into the marketplace and deliver the rights to the lender. When a spin-off occurs, the borrower owes both the original security and the spin-off security to the lender (the borrower is now short two securities).