How does the person lending shares to the short selller protect themselves if the short sellers are correct?
"Lending of shares happens in the background. Those who have lent them out are not aware that they have been lent out, nor when they are returned. The borrowers have to pay any dividends to the lenders and in the end the borrowers get their stock back. If you read the fine print on the account agreement for a margin account, you will see that you have given the brokerage the permission to silently loan your stocks out.  Since the lending has no financial impact on your portfolio, there's no particular reason to know and no particular protection required.  Actually, brokers typically don't bother going through the work of finding an actual stock to borrow.  As long as lots of their customers have stocks to lend and not that many people have sold short, they just assume there is no problem and keep track of how many are long and short without designating which stocks are borrowed from whom. When a stock becomes hard to borrow because of liquidity issues or because many people are shorting it, the brokerage will actually start locating individual shares to borrow, which is a more time-consuming and costly procedure.  Usually this involves the short seller actually talking to the broker on the phone rather than just clicking ""sell.""" "It is true, as farnsy noted, that you generally do not know when stock that you're holding has been loaned by your broker to someone for a short sale, that you generally consent to that when you sign up somewhere in the small print, and that the person who borrows has to make repay and dividends. The broker is on the hook to make sure that your stock is available for you to sell when you want, so there's limited risk there. There are some risks to having your stock loaned though.  The main one is that you don't actually get the dividend.  Formally, you get a ""Substitute Payment in Lieu of Dividends.""  The payment in lieu will be taxed differently.  Whereas qualified dividends get reported on Form 1099-DIV and get special tax treatment, substitute payments get reported on Form 1099-MISC. (Box 8 is just for this purpose.)  Substitute payments get taxed as regular income, not at the preferred rate for dividends. The broker may or may not give you additional money beyond the dividend to compensate you for the extra tax. Whether or not this tax difference matters, depends on how much you're getting in dividends, your tax bracket, and to some extent your general perspective. If you want to vote your shares and exercise your ownership rights, then there are also some risks.  The company only issues ballots for the number of shares issued by them.  On the broker's books, however, the short sale may result in more long positions than there are total shares of stock. Financially the ""extra"" longs are offset by shorts, but for voting this does not balance. (I'm unclear how this is resolved - I've read that the the brokers essentially depend on shareholder apathy, but I'd guess there's more to it than that.) If you want to prevent your broker from loaning out your shares, you have some options:"
"There are two primary reasons shares are sold short:  (1) to speculate that a stock's price will decline and (2) to hedge some other related financial exposure. The first is acknowledged by the question.  The second reason may be done for taxes (shorting ""against the box"" was once permitted for tax purposes), for arbitrage positions such as merger arbitrage and situations when an outright sale of stock is not permitted, such as owning restricted stock such as employer-granted shares. Why would a shareholder lend the investor the shares? The investor loaning his stock out to short-sellers earns interest on those shares that the borrower pays.  It is not unusual for the annualized cost of borrowing stock to be double digits when there is high demand for heavily shorted shares.  This benefit is however not available to all investors." "Q: A: Everyone that is short is paying interest to the owners of the shares that the short seller borrowed. Although this quells your conundrum, this is also unrelated to the term. Interest in this context is just the number. In the options market, each contract also has an open interest, which tells you how many of that contract is being held. For your sake, think of it as ""how many are interested"", but really its just a completely different context." "There are situations where you can be forced to cover a position, particular when ""Reg SHO"" (""regulation sho"") is activated. Reg SHO is intended to make naked short sellers cover their position, it is to prevent abusive failure to delivers, where someone goes short without borrowing someone else's shares. Naked shorting isn't a violation of federal securities laws but it becomes an accounting problem when multiple people have claims to the same underlying assets. (I've seen companies that had 120% of their shares sold short, too funny, FWIW the market was correct as the company was worth nothing.) You can be naked short without knowing it. So there can be times when you will be forced to cover. Other people being forced to cover can result in a short squeeze. A risk. The other downside is that you have to pay interest on your borrowings. You also have to pay the dividends to the owner of the shares, if applicable. In shorter time frames these are negligible, but in longer time frames, such as closer to a year or longer, these really add up. Let alone the costs of the market going in the opposite direction, and the commissions." Well, if the short seller has to pay the dividend out of their pocket, what happens to the dividend the company paid out ??  Sounds like there are 2 divdends floating around, the short's, and the company's, but only 1 share of stock. In terms of pricing the asset, this functions in exactly the same way as a regular sell, so bids will have to be hit to fill the trade. When shorting an equity, currency is not borrowed; the equity is, so the value of per share liability is equal to it's last traded price or the ask if the equity is illiquid. Thus when opening a short position, the asks offer nothing to the process except competition for your order getting filled. Part of managing the trade is the interest rate risk.  If the asks are as illiquid as detailed in the question, it may be difficult even to locate the shares for borrowing. As a general rule, only illiquid  equities or those in free fall may be temporarily unable for shorting. Interactive Brokers posts their securities financing availabilities and could be used as a proxy guide for your broker. "Concerning the general problem of short selling and the need to borrow shares to complete the transaction : Selling short is a cash transaction.  Unlike a futures contract, where a short seller is entering into a legal agreement to sell something in the future, in the case of short selling a share the buyer of the share is taking immediate delivery and is therefore entitled to all of the benefits and rights that come with share ownership.  In particular, the buyer of the shares is entitled to any dividends payable and, where applicable, to vote on motions at AGMs.  If the short seller has not borrowed the shares to sell, then buyer of non-existent shares will have none of the rights associated with ownership. The cash market is based on the idea of matching buyers and sellers.  It does not accommodate people making promises. Consider that to allow short sellers to sell shares they have not borrowed opens up the possibility of the aggregate market selling more shares than actually exist.  This would lead to all sorts of problematic consequences such as heavily distorting the price of the underlying share.  If everyone is selling shares they have not borrowed willy-nilly, then it will drive the price of the share down, much to the disadvantage of existing share holders. In this case, short sellers who have sold shares they have not already borrowed would be paying out more in dividends to the buyers than the total dividends being paid out by the underlying company. There are instruments that allow for short selling of unowned shares on a futures basis.  One example is a CFD = Contract for Difference.  In the case of CFDs, sellers are obliged to pay dividends to buyers as well as other  costs related to financing. EDIT Regarding your comment, note that borrowing shares is not a market transaction.  Your account does not show you buying a share and then selling it.  It simply shows you selling a share short.  The borrowing is the result of an agreement between yourself and the lender and this agreement is off market.  You do not actually pay the lender for the shares, but you do pay financing costs for the borrowing so long as you maintain your short position. EDIT I realise that I have not actually read your question correctly.  You are not actually talking about ""naked"" short selling.  You are talking about selling shares you already own in a hope of maintaining both a long and short position (gross).  The problem with this approach is that you must deliver the shares to the buyer.  Otherwise, ask yourself what shares is the buyer actually buying if you want the bought shares to remain in your account. If you are not going to deliver your long position shares, then you will need to borrow the shares you are selling short for the reasons I have outlined above." "With (1), it's rather confusing as to where ""interest"" refers to what you're paying and where it refers to what you're being paid, and it's confusing what you expect the numbers to work out to be. If you have to pay normal interest on top of sharing the interest you receive, then you're losing money. If the lending bank is receiving less interest than the going market rate, then they're losing money. If the bank you've deposited the money with is paying more than the going market rate, they're losing money. I don't see how you imagine a scenario where someone isn't losing money. For (2) and (3), you're buying stocks on margin, which certainly is something that happens, but you'll have to get an account that is specifically for margin trading. It's a specific type of credit with specific rules, and you if you want to engage in this sort of trading, you should go through established channels rather than trying to convert a regular loan into margin trading. If you get a personal loan that isn't specifically for margin trading, and buy stocks with the money, and the stocks tank, you can be in serious trouble. (If you do it through margin trading, it's still very risky, but not nearly as risky as trying to game the system. In some cases, doing this makes you not only civilly but criminally liable.) The lending bank absolutely can lose if your stocks tank, since then there will be nothing backing up the loan." "And what exactly do I profit from the short? I understand it is the difference in the value of the stock. So if my initial investment was $4000 (200 * $20) and I bought it at $3800 (200 * $19) I profit from the difference, which is $200. Do I also receive back the extra $2000 I gave the bank to perform the trade? Either this is extremely poorly worded or you misunderstand the mechanics of a short position.  When you open a short position, your are expecting that the stock will decline from here.  In a short position you are borrowing shares you don't own and selling them.  If the price goes down you get to buy the same shares back for less money and return them to the person you borrowed from.  Your profit is the delta between the original sell price and the new lower buy price (less commissions and fees/interest).  Opening and closing a short position is two trades, a sell then a buy.  Just like a long trade there is no maximum holding period. If you place your order to sell (short) 200 shares at $19, your initial investment is $3,800.   In order to open your $3,800 short position your broker may require your account to have at least $5,700 (according to the 1.5 ratio in your question).  It's not advisable to open a short position this close to the ratio requirement.  Most brokers require a buffer in your account in case the stock goes up, because in a short trade if the stock goes up you're losing money.  If the stock goes up such that you've exhausted your buffer you'll receive what's known as a ""margin call"" where your broker either requires you to wire in more money or sell part or all of your position at a loss to avoid further losses.  And remember, you may be charged interest on the value of the shares you're borrowing. When you hold a position long your maximum loss is the money you put in; a position can only fall to zero (though you may owe interest or other fees if you're trading on margin).  When you hold a position short your maximum loss is unlimited; there's no limit to how high the value of something can go.  There are less risky ways to make short trades by using put options, but you should ensure that you have a firm grasp on what's happening before you use real money. The timing of the trades and execution of the trades is no different than when you take a plain vanilla long position.  You place your order, either market or limit or whatever, and it executes when your trade criteria occurs." I'm just began playing in the stock   market. I assume you mean that you're not using real money, but rather you have an account with a stock simulator like the one Investopedia offers. I am hopeful that's the case due to the high level of risk involved in short selling like you're describing. Here is another post about short selling that expands a bit on that point. To learn much more about the ins and outs of short selling I will point again to Investopedia. I swear I don't work for them, but they do have a great short selling tutorial.  When you short sell a stock you are borrowing the stock from your broker. (The broker typically uses stock held by one or more of his clients to cover the loan.) Since it's basically a loan you pay interest. Of course the longer you hold it the more interest you pay. Also, as Joe mentioned there are scenarios in which you may be forced to buy the stock (at a higher price than you sold it). This tends to happen when the stock price is going against the short sell (i.e. you lose money). Finally, did anyone mention that the potential losses in a short sell are infinite? "Take the case where a stock has just two owners, A and B, both at $10. One of them sells his shares to C, at $11.  Now B has made $1 in profit but is no longer an owner of the stock. A hasn't sold anything but his shares are worth 10% more due to the last traded price printed. C has bought shares at $11 and the price is $11, so technically he hasn't lost any money. In a larger market, there are winners and losers every day on a single stock, but they may not remain owners of a stock. There could be days in which those that remain owners are all winners - say when a stock goes up to an all time high and all those that are currently owners have an average buy price lower than the last traded price. And the reverse applies too.  It is of course more complicated. Say you own a stock and let someone else ""borrow"" it for a short-selling opportunity (he sells it in the market). For each uptick in price, you win, the short seller loses, and the guy he sold it to also wins. A person that has a covered call on a stock is not a winner beyond a point. And so on." "If the owner of the stock wants it back, they ""call"" it back. There are no guarantees of how long you can keep it for your short, or the cost involved to hold it.  Usually, everyone knows about a particular set-up (e.g. a warrant or convertible bond mispricing) that is attractive for arbitrage. This causes the associated stock to be in high demand thus expensive to borrow for shorting, or impossible to find for any price at all." "My problem with your argument is that you don't have one.   I'm sorry you cannot grasp the difference between mortgage backed securities and company stock or the difference between a short sale and buying a credit default swap. You keep spouting unrelated ""facts"" as if the mean something.  Did big banks short sale FB?  Who knows?  Did they buy FB CDOs?  No they didn't.  There is no such thing. Did they buy credit default swaps? No." "You didn't win in case B. Borrowing shares and then selling them is known as ""selling short"".  You received $2000 when you sold short 100 shares at $20.  You spent $1000 to buy them back at $10, so you come out $1000 ahead on that deal.  But at the same time, the 100 shares you already owned have declined in value from $20 to $10, so you are down $1000 on that deal.  So you've simply broken even, and you are still out the interest and transaction fees. In effect, a short sale allows you to sell shares you don't own.  But if you do already own them, then the effect is the same as if you just sold your own shares.  This makes it easier to see that this is just a complicated and expensive way of accomplishing nothing at all." The one thing your friend needs to understand is for every dollar paid out, there is somebody paying that dollar in.  The mark of a Ponzi scheme is that it feeds on itself. The stock market has trade volumes where it almost meets the definition of a Ponzi scheme.  However, it deals with shares in actual production facilities (rather than only financial institutions) and provides means of production in return for large amounts of the profits.  So there is someone legitimately expecting to pay back more than he gets out, in return for the availability of money at a time where he could not finance matters except by credit. With your friend's scheme, there is nobody expected to pay more than he gets out. Nail him down with that: every dollar paid out has to be paid in.  Who is the one paying? At this point of time, it sounds like there will be two possible outcomes.  You'll be visiting your friend in debtors' prison, or you'll visit him in criminal prison.  If you highly value your friendship, you might get him out of the former with your own money.  You won't be able with the latter.  And if you let him exploit his standing for scamming his community, make no mistake, it will be the latter. I don't envy you. In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. Remember your broker has to borrow it from somewhere, other clients or if they hold those specific stocks themselves. So if it isn't possible for them to lend you those stocks, they wouldn't. High P/E stocks would find more sellers than buyers, and if the broker has to deliver them, it would be a nightmare for him to deliver all those stocks, which he had lent you(others) back to whom he had borrowed from, as well as to people who had gone long(buy) when you went short(sell). And if every body is selling there is going to be a dearth of stocks to be borrowed from as everybody around is selling instead of buying.