I have never done a short sale. My understanding is that you effectively borrow shares of a stock to sell today, with the expectation that the price will drop. When it does, you buy some to return to where you borrowed it from. This allows you to realize a gain from the price drop, while the party you borrowed from suffers an unrealized loss.
Where do you borrow it from?
You borrow it from your brokerage firm.
When most people buy stock, they don’t actually take possession of the stock, they leave it with the broker. If they have purchased those stocks on margin, the broker has the right to lend those shares out (this is part of the agreement you made to be able to buy on margin). Those are the shares that the short seller borrows. If the original buyer decides to sell his shares and the broker cannot locate other shares to take their place, the broker can force you to liquidate your short position. Furthermore, if the shares you borrowed continue to rise in price, the broker can demand that you deposit more funds to cover the difference (similar to a margin call).
It should also be noted that the short seller is paying interest in return for borrowing the shares, so it’s not like he can keep them forever for free. I am not really sure who gets the interest, but I think it is the broker, not the owner of the stocks.
There are other variations on this theme, like “naked” short selling, but I don’t really understand that.
Well, I probably don’t understand it any better than you do but in that case you are selling stock that you didn’t even borrow. You are selling stock you don’t have at all. What I don’t understand is why anybody would buy stock from you if you can’t deliver it at the time of sale.
Take a look at this article about Naked Short Selling
http://www.bloggingstocks.com/2009/04/08/sec-stop-naked-short-selling/
It basically means that you can :
Short selling by itself is not wrong nor is it illegal. What is wrong is naked short selling. SEC regulation SHO permits naked short selling. Short sellers were supposed to first borrow the stock, usually from a brokerage house before selling it so they would have something to sell. They would then buy it back (hopefully at a lower price) and give that stock back to the lender. That has been the rule as long as we have had short sales. However the SEC enacted regulation SHO the permits naked short selling. Naked short selling is where you just sell the stock without first borrowing it from a lender. This is called a “fail to deliver” trade. The downfall of Lehman Brother was caused in part by the excessive naked short selling of an astounding 38 million shares and the SEC has done nothing to bring the naked short sellers to justice. Now you know damn well that a short seller knows if he/she has first borrowed the stock before making the short sale. If not they shouldn’t be trading.
Now isn’t that nice…only on Wall Street.
This gives me a great idea, a friend has some swamp property in Leavittsburg, Ohio by the river. I could sell it as prime beach property cause of all the sand around it. Make a BIG buck from selling it, then when the buyer realizes its just a swamp, buy it back for pennies on the dollar that they paid me for it. My friend will never know cause he still owns it. An I still made a killing on it and never actually owned it. If any legal issues come up, I’ll just explain that on Wall St. its done every day and its perfectily legal. If its good enough for the SEC on Wall St. and our federal gov’t is ok with it, then it should be ok for everybody. Then everybody thought Madoff was the biggest crook on Wall St., there’s thousands of them.