How Short Selling Works

As the short seller has sold stock but not received cash he or she will miss out on the ability to reinvest the sale proceeds that are now in the hands of the stock lender. The stock lender appears to get a free lunch from this transaction by benefiting from the reinvestment of the sale proceeds. If you are an individual investor, then this is indeed the case. However, if you are an institutional investor , such as a hedge fund or pension plan , then this inequality is cured by the stock lender paying a rebate to the selling broker. The rebate represents a sharing arrangement on the interest that the stock lender earns on the collateral, which it holds. For example, if the stock lender earns 3.5% on the cash it holds, it might pay the short seller 3.0%.

Furthermore, institutional short sellers may have to pay a fee instead of receiving a rebate on stocks that are hard to borrow (in other words, stocks that are in limited supply with large short seller demand). As an example, Amazon.com (AMZN Quote) may be a stock which is heavily shorted with a limited amount of stock that can be borrowed. So an institutional borrower of Amazon might have to pay a fee of 2% instead of receiving a rebate in order to borrow Amazon stock.

When all aspects of the short sale transaction and process are put together, this creates a "short position " for the short seller.

Short Covering

At a later date, the short seller will "cover" the short position. When the short seller does this, he or she will buy the same stock in the open market and the entire process that I've described so far will unwind.

The short seller buys stock from another seller. The short seller's broker will then pay for the stock out of it's client account, by using the stock to then return the stock loan to the stock lender, freeing up the cash collateral and margin requirement in the process.

So, how does a short seller economically benefit from this series of transactions? Like any other investment. As a short seller, if you sell for more than you buy then you will generate a profit. The short sale process, however, creates this optical illusion since the sale comes before the purchase. Simply put, if the price of the short sale was greater than the price at which the "buy to cover" took place, then the short seller will make money. On the other hand, if the price of the short sale is less than the price of the buy to cover, then the short seller will lose money.