A short seller sells shares it does not have and promises to deliver them anyway. Every rule in this lesson asks one question: will those shares show up at settlement, and what happens if they don't?
In an ordinary trade you buy first and sell later, and a short sale reverses that order. The Securities and Exchange Commission (SEC) governs short selling through Regulation SHO. Its Rule 200(a) defines a short sale as any sale of a security the seller does not own, or any sale completed with borrowed shares.
The short sale basics run in three steps:
- The seller borrows shares, usually through the brokerage firm, sells them at today's price and delivers the borrowed shares to the buyer.
- The seller owes them back later. Closing the position is called covering: the seller buys the same number of shares and returns them to the lender.
- The seller profits if the price falls, because the shares are bought back for less than they sold for. If the price rises, the seller loses.
Common mistakes
- Counting the dividend as income. It is a payment the short seller owes the lender; 500 shares at $0.75 cost $375.
- Using stale close-out days. T+3 and T+5 belong to the old cycle. Under T+1, use T+2 for short sales and T+4 for long sales; the 35 calendar days are unchanged.
- Calling Rule 201 a ban or uptick test. Short sales above the national best bid still execute, and the restriction ends after the next trading day.
Bottom line
- A short seller borrows, sells and owes the shares back; gain is capped at the sale price, loss is unlimited, and dividends paid to the lender are a cost.
- Shorting against the box locks in price but is a constructive sale under IRC Section 1259, so the gain is recognized now.
- Rule 200(g): every equity sell order is marked long, short or short exempt; long requires net long ownership plus shares in the firm's control or expected by settlement.
- Rule 203(b): borrow, arrange to borrow or have reasonable grounds, and document it before a short sale; bona fide market making is exempt; easy-to-borrow lists must be under 24 hours old.
Exam shortcut
Place each short-sale question in its stage first: marking, locate, execution, settlement or lending. Then apply that stage's single test. Marking asks "net long and in the firm's control by settlement?" Execution on a restricted day asks "above the national best bid?" For a fail, count settlement days from settlement date: one for a short sale, three for a long sale or market maker.
The full lesson (about 3,687 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- D32
Browse all free Series 7 lessons or jump into free Series 7 practice questions.