Short selling stock consists of the following:

• The investor instructs the broker to sell the shares and the proceeds are credited to his broker's account at the firm upon which the firm can earn interest. Generally, the short seller does not earn interest on the short proceeds.

• Upon completion of the sale, the investor has 3 days (in the US) to borrow the shares. If required by law, the investor first ensures that cash or equity is on deposit with his brokerage firm as collateral for the initial short margin requirement. Some short sellers, mainly firms and hedge funds, participate in the illegal practice of naked short selling, where the shorted shares are not borrowed or delivered.

• The investor may close the position by buying back the shares (called covering). If the price has dropped, he makes a profit. If the stock advanced, he takes a loss.

• Finally, the investor may return the shares to the lender or stay short indefinitely.

• At any time, the lender may call for the return of his shares i.e. because he wants to sell them. The borrower must buy shares on the market and return them to the lender (or he must borrow the shares from elsewhere). When the broker completes this transaction automatically, it is called a 'buy-in'.

Shorting stock in the U.S.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate.” Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security.

The vast majority of stocks borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below). Institutions often lend out their shares in order to earn a little extra money on their investments. These institutional loans are usually arranged by the custodian who holds the securities for the institution. In an institutional stock loan, the borrower puts up cash collateral, typically 102% of the value of the stock. The cash collateral is then invested by the lender, who often rebates part of the interest to the borrower. The interest that is kept by the lender is the compensation to the lender for the stock loan.

Brokerage firms can also borrow stocks from the accounts of their own customers. Typical margin account agreements give brokerage firms the right to borrow customer shares without notifying the customer. In general, brokerage accounts are only allowed to lend shares from accounts for which customers have "debit balances", meaning they have borrowed from the account. SEC Rule 15c3-3 imposes such severe restrictions on the lending of shares from cash accounts or excess margin (fully paid for) shares from margin accounts that most brokerage firms do not bother except in rare circumstances. (These restrictions include the broker must have the express permission of the customer and provide collateral or a letter of credit.)

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been legally sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares legally sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements but in order to be reliable, investors must also ascertain the number of shares brought into existence by naked shorters. Investors are cautioned to remember that for every share that has been shorted (owned by a new owner), a 'shadow owner' exists (i.e. the original owner) who also is part of the universe of owners of that stock, i.e. Despite not having any voting rights, he has not relinquished his interest and some rights in that stock.

Securities lending

When a security is sold, the seller is contractually obliged to deliver it to the buyer. If a seller sells a security short without owning it first, the seller needs to borrow the security from a third party to fulfill its obligation. Otherwise, the seller will "fail to deliver," the transaction will not settle, and the seller may be subject to a claim from its counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as securities lending. The lender receives a fee for this service. Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.

Sources of short interest data

Time delayed short interest data (for legally shorted shares) is available in a number of countries, including the US, the UK, Hong Kong, and Spain. Some market participants (like Data Explorers and [http://www.sungard.com/financialsystems/products/shortsidecom.aspx ShortSide.com]) believe that stock lending data provides a good proxy for short interest levels (excluding any naked short interest). The amount of stocks being shorted on a global basis has increased in recent years for various structural reasons (e.g. the growth of 130/30 type strategies, short or bear ETFs).

Short selling terms

Days to Cover (DTC) is a numerical term that describes the relationship between the amount of shares in a given equity that have been legally short sold and the number of days of typical trading that it would require to 'cover' all legal short positions outstanding. For example, if there are ten million shares of XYZ Inc. that are currently legally short sold and the average daily volume of XYZ shares traded each day is one million, it would require ten days of trading for all legal short positions to be covered (10 million / 1 million).

Short Interest is a numerical term that relates the number of shares in a given equity that have been legally shorted divided by the total shares outstanding for the company, usually expressed as a percent. For example, if there are ten million shares of XYZ Inc. that are currently legally short sold and the total, number of shares issued by the company is one hundred million; the Short Interest is 10% (10 million / 100 million). If however, shares are being created through naked short selling, "fails" data must be accessed to assess accurately the true level of short interest.

= Major lenders

• Merrill Lynch (New Jersey)
• State Street Corporation (Boston)
• JP Morgan Chase (New York)
• Northern Trust (Chicago)
• Fortis (Amsterdam)
• Citibank (New York)
• Bank of New York Mellon Corporation (New York)
• UBS AG (Zurich, Switzerland)

Naked short sale

A naked short sale occurs when a security is sold short without borrowing the security within a set time, 3 days (T+3) in the US. This means that the buyer of such a short is buying the short-seller's promise to deliver a share, rather than buying the share itself. The short-seller's promise is known as a hypothecated share.

When the holder of the underlying stock receives a dividend, the holder of the hypothecated share would receive an equal dividend from the short seller.

Naked shorting has been made illegal except where allowed under limited circumstances by market makers. It is detected by the Depository Trust & Clearing Corporation (in the US) as a "failure to deliver" or simply "fail.” While many fails are settled in a short time, some have been allowed to linger in the system.

In the US, arranging to borrow a security before a short sale is called a locate. In 2005, to prevent widespread failure to deliver securities, the U.S. Securities and Exchange Commission (SEC) put in place Regulation SHO, intended to prevent investors from selling some stocks short before doing a locate. Requirements that are more stringent were put in place in September 2008, to prevent the practice from exacerbating market declines. The rules were made permanent in 2009.

Short Selling Mechanism Topic - Short Selling

In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender.