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.
To enact a short sale, Trader A must first confirm that he will be able to borrow the number of shares he plans to sell. Brokers keep a list of available inventory on what is called a Box List. Brokers populate the Box List through their own inventory and shares of others, including their customers who borrow on margin and agree to lend their shares, and other third-party brokers.
2. Execute a short sale trade.
After locating available shares, Trader A executes a short sale trade on trade date, or “T.” Most major equity markets have a three-day settlement period, which means that the exchange of shares for cash occurs three days following the trade date, or “T+3.” .
3. Shares are borrowed and the short sale transaction settles.
On the morning of T+3, Trader A's Securities Lending Department determines its actual delivery obligations for that day. They consult their Box List and use the shares to settle the short sale. As with the short sale availability process, in the case that their own Box List does not contain borrowable inventory, they consult and use shares from the Box List of other brokers.
It is important to understand that there may be times where a given stock appears to be borrowable on T, but in the intervening three days the availability changes such that on T+3 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.
When the trade settles, the cash received from selling the shares is used as collateral on Trader A's borrowed shares. Trader A's Broker invests the cash collateral.
5. Interest is paid to or by the short seller( if applicable).
A portion of the interest from the invested collateral is used to pay administration fees and stock borrowing fees. Because of steep administration costs, remaining interest is generally only paid out to large balance short sellers. In certain hard to borrow cases, borrowing fees are so high (greater than the interest earned) that the short seller ends up paying additional interest for the privilege of borrowing a security. Customers may view the indicative short stock interest rates for a specific stock through the Short Stock (SLB) Availability tool located in the Tools section of their Account Management page.
6. Payments in Lieu of Dividends made by short seller (if required).
If the stock in the short sale pays dividends, the purchaser of the stock receives the dividend payments. However, the lender of the shares is also entitled to dividend payments since he did not sell the stock but is only lending it. Trader A is responsible to making these payments to the lender in the form Payment in Lieu of Dividends.
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.