A short sale is a common type of trade in the financial world. It involves selling an asset that a trader does not own. The trader borrows the asset, then—by a specified later date—buys it back and returns it to the asset's owner. The investment philosophy is that the borrowed asset will decline in price and the investor will earn a profit by selling at a higher price and buying back at the lower price. Selling short is done on margin and is a risky endeavor due to its unlimited potential for loss.
In determining who benefits from lending shares in a short sale, we first need to clarify who is doing the lending in a short sale transaction. Many individual investors think that—because their shares are the ones lent to the borrower—they will receive some benefit, but this is not the case.
Benefits From Lending Shares
When a trader wishes to take a short position, they borrow the shares from a broker without knowing where the shares come from or to whom they belong. The borrowed shares may be coming out of another trader's margin account, out of the shares held in the broker's inventory, or even from another brokerage firm. It is important to note that when the transaction has been placed, the broker is the party doing the lending, not the individual investor. So, any benefit received (along with any risk) belongs to the broker.
The broker does receive an amount of interest for lending out the shares and is also paid a commission for providing this service. In the event that the short seller is unable (due to a bankruptcy, for example) to return the shares they borrowed, the broker is responsible for returning the borrowed shares. Though this is not a huge risk to the broker due to margin requirements, the risk of loss is still there, and this is why the broker receives the interest on the loan.
In the event that the lender of the shares wishes to sell the stock, the short seller is generally not affected. The brokerage firm that lent the shares from one client's account to a short seller will usually replace the shares fromits existing inventory. The shares are sold and the lender receives the proceeds of the sale into their account. The brokerage firm is still owed the shares by the short seller.
The main reason why the brokerage—not the individual holding the shares—receives the benefits of lending shares in a short sale transaction can be found in the terms of the margin account agreement. When a client opens a margin account, there is usually a clause in the contract that states that the broker is authorized to lend—either to itself or to others—any securities held by the client. By signing this agreement, the client forgoes any future benefit of having their shares lent out to other parties.
The Bottom Line
Short selling is a risky trade but can be profitable if executed correctly with the right information backing the trade. In a short sale transaction, a broker holding the shares is typically the one that benefits the most, because they can charge interest and commission on lending out the shares in their inventory. The actual owner of the shares does not benefit due to stipulations set forth in the margin account agreement.
FAQs
In a short sale transaction, a broker holding the shares is typically the one that benefits the most, because they can charge interest and commission on lending out the shares in their inventory. The actual owner of the shares does not benefit due to stipulations set forth in the margin account agreement.
Who do you borrow shares from when shorting? ›
Because you're borrowing shares from a brokerage firm, you must first establish a margin account to hold eligible assets like bonds, cash, mutual funds, or stocks as collateral.
Who benefits from stock lending? ›
If you own a large position in one or more stocks, lending your shares can be an easy way to earn passive income from your idle investments. Stock lending programs give you cash payments every time your shares are lent out, which you can reinvest, put toward diversification, or spend on other expenses.
Why do companies lend shares to short sellers? ›
In order to profit from the potential discrepancy between the two prices, short sellers must first find shares to borrow—which is where securities lending comes in. Such programs allow individual clients to lend in-demand stocks to their broker, who then lends the shares to short sellers, with interest.
How do lenders make money on short selling? ›
By facilitating shorting, and presumably taking a cut of any profit or charging the borrower a fee, the lender gets to keep the share whilst participating in any fall in value which, after receiving the cut or fee, might compensate for any drop in value.
Who benefits from lending shares in a short sale? ›
In a short sale transaction, a broker holding the shares is typically the one that benefits the most, because they can charge interest and commission on lending out the shares in their inventory. The actual owner of the shares does not benefit due to stipulations set forth in the margin account agreement.
How do I stop short sellers from borrowing my shares? ›
Opt out of any securities lending programs, which should stop your broker from lending your shares. Move your shares to a Direct Registration (“DRS”) account at the Company's transfer agent, Computershare.
Can my broker lend out my shares to short sellers without asking? ›
> brokers cannot lend your shares without a written agreement allowing it.
Can you make money from lending your shares? ›
For shareholders, stock lending offers a relatively low-risk way to earn extra returns on the stocks you already own. You maintain ownership of your stocks the whole time. If loaned stocks go up in value, those returns are still yours. If you decide to sell your stocks while they're loaned out, you can.
Is there any downside to stock lending? ›
What about the risks? As with all investment strategies, lending securities involves risk that needs to be considered. The main risks are that the borrower becomes insolvent and/or that the value of the collateral provided falls below the cost of replacing the securities that have been lent.
Put simply, a short sale involves the sale of a stock an investor does not own. When an investor engages in short selling, two things can happen. If the price of the stock drops, the short seller can buy the stock at the lower price and make a profit. If the price of the stock rises, the short seller will lose money.
How profitable is stock lending? ›
It's hard to say how much you may earn from stock lending since the payout can depend on how much a borrower wants it. Stocks with low availability and high demand are typically the most likely to result in higher earnings for the stock lender since they're most likely to get borrowed by other parties.
How do short sellers make a stock go down? ›
Short sellers are wagering that the stock they're shorting will drop in price. If this happens, they will get it back at a lower price and return it to the lender. The short seller's profit is the difference in price between when the investor borrowed the stock and when they returned it.
Why would a lender do a short sale? ›
Since a short sale generally costs the lender less than a foreclosure, it can be a viable way for a lender to minimize its losses. A short sale can also be the best option for a homeowners who are “upside down” on mortgages because a short sale may not hurt their credit history as much as a foreclosure.
What is the logic behind short selling? ›
Short selling is a trading strategy that allows investors to profit from a fall in the value of an asset. Rather than buying a stock you expect to rise in value, the basic position is that you are taking a bet against a stock.
Do short sellers hurt a company? ›
It is widely agreed that excessive short sale activity can cause sudden price declines, which can undermine investor confidence, depress the market value of a company's shares and make it more difficult for that company to raise capital, expand and create jobs.
Who provides the shares for short selling? ›
Short selling a stock is when a trader borrows shares from a broker and immediately sells them with the expectation that the share price will fall shortly after.
How do you short a stock without borrowing? ›
Naked short selling is a high-risk and ethically dubious financial practice where an investor sells a security, often shares of stock, without first borrowing the asset or ensuring its availability for borrowing. The process involves selling shares one does not own and later buying them back to cover the position.
Where does the money come from when you short a stock? ›
Short sellers are wagering that the stock they're shorting will drop in price. If this happens, they will get it back at a lower price and return it to the lender. The short seller's profit is the difference in price between when the investor borrowed the stock and when they returned it.
How do hedge funds borrow shares for short selling? ›
It consists of a two-step transaction whereby an investor, like a hedge fund, first borrows the shares from a lender (for example Fidelity or Vanguard) and then immediately sells these borrowed shares to other traders in the stock market.
