How Are Shares Borrowed to Sell Short?

Short selling is a trading technique that lets a trader profit from a stock price decline. If a trader believes that a stock will decline, he borrows shares of that stock from his broker, sells them, keeps the proceeds, buys the shares back at a lower price and returns them to the broker. His profit is the difference between the amount he gets when he sells the shares and the amount that he pays to buy them back. The key to the transaction is the trader's ability to borrow shares to sell short.

1. Margin Accounts

   • An investor can have either a cash or margin account. A standard margin account agreement stipulates that the broker can lend out the securities held in the customer's account without the customer's specific knowledge or consent. It means that for all intents and purposes, the investor continues to own the shares even when they have been loaned out to someone else. To borrow shares, a short seller must have a margin account.

   Process

   • The process of borrowing shares is fully automated. All a short seller has to do is enter the symbol, number of shares and click "Sell short." If the broker has enough shares to lend, the transaction is executed automatically like any other sell order; if not, the transaction is canceled.

   Margin Department

   • Every broker has a margin department that determines which stocks are marginable -- i.e. can be borrowed/loaned -- and which are available for short sales and in what quantities. A broker can only loan out to short sellers as many shares as there are available in customer margin accounts. If there is no or not enough stock available, the short sell will not go through and the short sell order will be canceled. In some instances, a broker may allow a short sell order to go through and borrow shares from another broker.

   Naked Shorting

   • The total number of shares available for shorting equals the number of shares held in margin accounts. The broker is responsible for locating available shares before loaning them but some unscrupulous brokers allow short selling without available shares -- a technique called naked shorting. It is obviously a highly risky strategy because unchecked naked shorting may result in more shares being shorted than there are issued and outstanding shares. If a shorted stock rises sharply and short sellers scramble to buy back the stock, there won't will be enough available for everyone to cover.