In finance, short selling (shorting, a short sale, going short) is a common method that is used to bet against a specific investment. If an investor is ‘short’ on Apple stock, then they will make money when Apple’s stock price falls, for example.
Many people are vaguely familiar with the general concept of short selling. However, far fewer understand the mechanics of how short selling a stock actually works in practice. To short sell a stock, you must first borrow the stock.
How Does Short Selling Actually Work?
To best understand short selling, consider the following example: An investor borrows 10 shares of a stock that is priced at $200 per share. Then the investor immediately sells all 10 shares. This investor has conducted a short sale. At this point, they will have $2,000 in cash, but they will also owe someone ten shares of the stock (valued at $2,000).
Assume that the stock price drops from $200 down to $150. The investor decides to close out the position and end the short. To do this, the investor must buy 10 more shares (now only priced at a total of $1,500) and return them to the lender. In this scenario, the investor would have made a profit of $500. Of course, if the stock price would have gone up during this period, the investor would have lost money.
Where are Short Sellers Borrowing Stock From?
To borrow a stock, you need someone to lend it. Brokerage firms fill this role. With limited exceptions, short sellers are borrowing from brokerage firms. Does that mean that your brokerage firm is lending out your securities to another party who is actively hoping to drive down the price of the stock? The answer: it might be.
To be clear, your brokerage firm cannot lend out your stocks without your permission. However, you may have signed a customer agreement that explicitly allows your broker to lend out your securities. This clause is often tucked deep within the customer agreement, and few investors pay much attention to it. In many cases, investors who have a margin account with their brokerage firm will be asked to sign a hypothecation agreement. This agreement generally gives the brokerage firm the right to lend shares of securities that you own.
Review Your Customer Agreement; Be Prepared to Ask Questions
All investors should have a comprehensive understanding of their relationship with their financial advisor and their brokerage firm. For example, you need to know whether you are working with a stockbroker or a registered investment advisor (RIA). While an RIA has a duty to act in your best financial interests (a fiduciary duty), a stockbroker only has a duty to offer you suitable investment advice. Many people do not realize the crucial difference.
In addition, you should know exactly what stocks you are holding and if your broker has the right to lend those securities to short sellers. Do not be afraid to ask questions. If you are not comfortable with the arrangement, you should be ready to ask for changes. Finally, if you believe that your broker or brokerage firm is committing fraud or acting in a negligent manner, you should speak to an experienced investment fraud lawyer immediately.
Contact a Broker Fraud Attorney Today
At Sonn Law Group, our investment fraud lawyers have extensive experience handling complex broker fraud and negligence claims. If you or a family member lost money because your broker’s lending of your shares, we can help. For a free, fully private review of your case, please do not hesitate to contact our law firm today.