How Short Selling Works

The Short Sale

The transaction (known as a "short sale") is initiated by an individual or organization (known as a "short seller"), who desires to "short " a stock. Once the stock is sold short, the short seller must deliver the stock to the buyer. The buyer cannot differentiate whether the seller is a short seller or a long seller of stock -- nor do they care. The buyer is only interested in receiving the stock they have paid for. The short seller has a problem though. He or she does not own the stock sold to the buyer. Hence, the short seller must borrow the stock to be able to deliver it to the buyer. How? The short seller will utilize a selling broker to arrange to borrow the stock from a stock lender to be used to satisfy the short seller's sale of stock to the buyer.

This transaction takes place in a margin account and might have other economic consequences, which I will discuss later on. Please note that in some instances, the selling broker may in fact be the stock lender while in other circumstances, the selling broker must borrow stock from a third party securities lender.

When the buyer receives the stock and pays for it, he or she is satisfied and no longer has any involvement in the transaction. The other three parties (the short seller, selling broker and stock lender) are still linked together by the stock loan.

Short Position

Since the stock lender has lent out securities, it will require that the borrower (the short seller) post collateral to secure the loan . This collateral is derived from the short sale proceeds, which the short seller receives from the buyer. However, the selling broker will actually receive the cash from the buyer and will not disburse it to the seller. Instead, the selling broker will withhold those short sale proceeds, make a "memo entry" in the short seller's account and then use the short sale proceeds to post as collateral against the stock that was borrowed from the stock lender.