How Does a Short Sale Work?
To understand how a short sale works, consider this scenario:
Trader A decides he wants to sell a stock short in hopes of being able to repurchase it at a lower price in the future.
1. Locate shares for shorting:
2. Execute a short sale trade:
3. Shares are borrowed and the short sale transaction settles:
It is important to understand that there may be times where a given stock appears to be borrowable on T but in the intervening two days the availability changes such that on T+2 it is no longer borrowable. This creates a situation in which the short sale trade will "fail;" in other words, the timely delivery obligation will not be met by the broker. In this case, a forced repurchase, or "buy-in" may be issued by the broker and the resulting buy trade will be charged to the Trader A’s account, thereby reducing or eliminating the short position.
4. Cash from the short sale is used as collateral on borrowed shares:
5. Interest is paid to or by the short seller( if applicable):
6. Payments in Lieu of Dividends are made by the short seller (if required):
At some point in the future, the need to maintain the borrow is reduced, either when Trader A decides to repurchase his short position, or if the shares are recalled by the lender. In the former case, the deal is closed. In the latter case, the broker will try to find another lender, the loan will be moved to the new trader or broker, and Trader A's short position will remain unaffected. In the case that no substitute loan can be arranged, the broker may notify Trader A that the loan has been recalled and that he must cover his position immediately. In many cases, the broker will simply execute the forced repurchase, or buy-in, of the recalled shares.
Effective September 5, 2017, the standard settlement period for securities traded on U.S. and Canadian exchanges was reduced from 3 business days (T+3) to 2 business days (T+2).
How were Short sale transactions impacted by this change? Under SEC Rule 204, brokers are required to close out short sales if they are unable to borrow securities and make delivery at settlement. Prior to September 5, 2017, closeouts were required to take place by no later than the beginning of regular trading hours on T+4. At the present time (post-September 5, 2017), the settlement cycle for short sales has been reduced to T+2. Therefore, closeouts must take place no later than the beginning of regular trading hours on T+3. (Closeout has been moved up 1 business day to T+3.)
What is a Short Sale? Risks of Short Selling How to Sell Short Short Stock Buy-in Procedures Exceptional Short Sale Regulations Reg SHO
(Mechanics of a Short Sale information compliments of IB, our clearing firm)