Lesson 7 of 9
Borrowing a share
A short position starts with a borrow and can end without your consent. The locate, the fee, the recall, and why the loss on a short has no ceiling.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Selling short means selling a share you borrowed, so the position begins with a loan of stock and ends when that loan is returned.
- The borrow has a price and the price changes daily, so a short that takes two years to be right can lose money while being right.
- A lender can recall the stock at any time, which closes the position on their schedule rather than yours.
A long position is bought and can be held indefinitely at no carrying cost. A short position is a borrowing arrangement that has to be maintained, paid for, and eventually unwound.
This lesson is mechanics, not a recommendation. Understanding how a short works matters to a long-only investor for one reason: forced covering is one of the few forces that can move a price a long way in a day with no news about the business.
The life of a short position
- 1Locatebroker confirms shares can be borrowed
- 2Borrow and sellshares delivered to the buyer, cash received
- 3Carryborrow fee daily, dividends paid to the lender
- 4Buy backshares repurchased in the market
- 5Returnloan closed, or closed for you by a recall
The locate comes first
Before accepting a short sale, a broker must have reasonable grounds to believe the shares can be borrowed and delivered by settlement. That check is the locate, and it is required by Regulation SHO.
For a widely held company with plenty of stock sitting in margin accounts, the locate is routine. For a small company where most holders do not lend, it can fail, and then the trade cannot be entered at all.
The borrow fee, and why it is the real constraint
The lender charges a fee, quoted as an annual rate on the value of the borrowed stock and accrued daily. In a liquid name it is a fraction of a percent a year and irrelevant. In a company that is hard to borrow it can run to tens of percent a year.
That fee is the reason a short can be correct and unprofitable. A position that costs 30 percent a year to carry needs the price to fall faster than the meter runs, and the meter runs every day including the ones where nothing happens.
The short seller also owes the lender any dividend paid while the stock is borrowed. It is not an expense the company charges; it is a substitute payment made so the lender is left where they started.
Recall, and the loss with no ceiling
The lender can demand the stock back. When that happens and the broker cannot find a replacement borrow, the position is bought in, at market, immediately.
What a long-only investor takes from this
Two things worth knowing, both of which show up on the tape rather than in the accounts.
Short interest is published, and a large short interest against a small borrowable float means that any forced covering has to compete for the same shares. That is the mechanism behind the sharp, newsless rallies that sometimes occur in heavily shorted companies.
And Rule 201 of Regulation SHO restricts short selling at prices at or below the national best bid for the rest of the day and the next, once a security has fallen 10 percent from the previous close. It is a circuit breaker on one side of the market, and it is one reason a falling share can behave oddly on the day after a large drop.
Check yourself
What must happen before a short sale is accepted?
- The seller must own the shares
- The broker must have reasonable grounds to believe the shares can be borrowed and delivered, which is the locate
- The exchange must approve the trade
Show the answer
Answer: B.
Regulation SHO requires the locate before a short sale is executed, so that delivery can be made at settlement.A short position costs 30 percent a year to borrow. What does that imply?
- Nothing, because the fee is paid by the broker
- The price must fall faster than the carrying cost accrues for the position to make money
- The position is guaranteed to be profitable
Show the answer
Answer: B.
The fee accrues daily on the value of the borrowed stock. Being right slowly and being wrong can produce the same result.Why does a short position get riskier as it moves against you?
- The borrow fee is fixed regardless of price
- The position grows in size as the price rises, so the same percentage move costs more each time
- Short positions cannot move against you
Show the answer
Answer: B.
A rising price increases both the loss and the size of the exposure. A long position does the opposite, shrinking as it falls.Sources
- Regulation SHO, Rule 203, on the locate requirement before a short sale.
- Regulation SHO, Rule 204, on the close-out requirement for failures to deliver.
- Regulation SHO, Rule 201, the alternative uptick rule, which restricts short selling at or below the national best bid after a 10 percent intraday decline.
- SEC investor education material on short sales, stock lending and substitute dividend payments.
What this leaves out
- The prices and the comparison table are illustrative round numbers. No real security is described and no short position is suggested.
- Borrow fees, availability and recall practice vary by broker and by security, and change daily. Nothing here states a rate.
- Short selling rules differ across jurisdictions and are periodically amended. Read the current rule text rather than this page.
- Nothing here is advice about any security or any strategy, and short selling carries loss potential that exceeds the amount committed.