How a Short gets Short

Bubba left a comment the other day and I wanted to respond to him because it was a pretty good question.

Bubba wanted to know why anyone in the world would lend out there shares to anyone and how is the person compensated for it?

Every transaction has 2 sides - the buyer and the seller. So when you sell something you do not own (short selling), you are still required to deliver shares to the new owner.

You do this by borrowing the shares from your broker. Virtually all of the shares today are held in book entry form or street name (which is in the name of the broker holding the shares). The reality is that "borrowing" is just an electronic book entry done at the broker level.

Unless the customer is so huge (like Calpers), the buyer will likely never know that his shares have been lent out.

Here's the downside for the seller.

1. Since the original buyer still owns the shares he loaned, he is entitled to the dividend if there is one. So as a short seller, I am obligated to pay the owner any dividends that he entitled to. So when I want to short something, I want to make sure there is no dividend or a really small one. The last thing I need is somebody's dividend being debited from my account.

2. The bigger snag happens when the original buyer wants to sell his shares. Since the original owner is still the rightful owner, he can sell his shares at any time.

When that happens, the person who borrowed the shares to short gets bought in at the very moment. No ifs ands or buts about it.

So if the buyer wants out, I get bought in and possibly at a time that just sucks from a trade standpoint. If I am short and have a loss because the price went up, too bad. My broker closes the trade and I get a confirm telling me I am out of the position.

That's one of the risks of being an outright short seller - I have no control over when I close my trade. There's only been a couple of times where I was bought in and each time it was at a loss for me.

The next obvious question is why not just re-short the position. That's when the wash-sale rule comes into play which simply means that I need to wait 30 days before re-establishing a position in the same or like security.

Hope this helps answer the question.

RAC
The Intelligent Trader