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I'm trying to wrap my head around short selling. Online the explanations i found talk about borrowing a stock from your broker, selling it at a high price then waiting for the stock to drop in price and buying it back for that low price, so you can return the stock to its original owners and pocket the difference, this i get. my question is, how can you sell something that you borrowed, how can you sell something that is not yours. like for example if i borrowed my friends car, i can't sell it because i wouldn't have the pink slip, so how can i sell stocks that i don't own? Thanks in advance.

  • Shorting a stock is legal in the US and illegal in some. This technique of trading helps bring 'balance' to the market in which provides liquidity in times when there is none. So wrap your head around the fact that you can short a stock - just because you can. – NuWin Apr 20 '16 at 6:36
  • If you are not in the USA, you may be able to trade with CFDs and go both long and short (many countries allow trading of CFDs but the USA does not). CFDs make it very easy to short stocks with no borrowing of stocks required before you short them, and because they are traded on margin you pay a small amount of interest each day you hold a long position overnight but you get paid a smaller amount of interest if you hold a short position overnight. – Victor Apr 20 '16 at 9:06
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If you had an agreement with your friend such that you could bring back a substantially similar car, you could sell the car and return a different one to him. The nature of shares of stock is that, within the specified class, they are the same. It's a fungible commodity like one pound of sand or a dollar bill. The owner doesn't care which share is returned as long as a share is returned.

I'm sure there's a paragraph in your brokerage account terms of service eluding to the possibility of your shares being included in short sale transactions.

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The original owner of the shares can pledge their shares to be short, and they earn interest from lending their shares.

The conditions of this arrangement are detailed in standard agreements all market participants sign with their broker, or clearinghouse, or with the exchange, or with the self regulatory agency.

Stocks within the same class are identical, despite someone's sentiment to an old share certificate that their grandparents gave them, and as such can be sold and returned to the beneficial owner multiple times with no difference.

That is how it is supposed to work anyway, as naked shorting involves selling fictional shares that have no beneficial owner. So there are market inefficiencies in this practice, but the agreements between market participants are sound and answers your question about how.

  • Which broker do you have that pays you interest for lending your shares to short-sellers? – user32479 Apr 20 '16 at 13:03
  • @Brick interactive brokers at one point had a section about being able to earn more interest by pledging shares. even if the broker doesn't pay the owner, the short seller pays margin – CQM Apr 20 '16 at 15:52
  • I don't know anything about interactive brokers, so I cannot say anything specific to them. Having used multiple other brokers, however, my experience is that several of your statements are much less general than you've made them sound. I've not personally seen individual owners receive interest for this or have any clear way to opt out of having their shares lent. I've also seen deals where short-selling does not require paying margin interest. The brokers have some leeway to set this up how they want, and different ones are doing it differently. – user32479 Apr 20 '16 at 16:18
  • @Brick yes, the capabilities can be used strategically, I know a guy caused a massive short squeeze to get the stock price up, by disabling the ability of his shares to be lent (he either told his broker, or simply bluffed on twitter that his lawyer suggested he remove his shares from the lending pool). He owned 70% of the float so it was the majority of where the short shares could come from – CQM Apr 20 '16 at 17:57
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My take on this is that with any short-selling contract you are engaging in, at a specified time in the future you will need to transfer ownership of the item(s) you sold to the buyer.

Whether you own the item(s) or in your case you will buy your friend's used car in the meantime (or dig enough gold out of the ground - in the case of hedging a commodity exposure) is a matter of "trust". Hence there is normally some form of margin or credit-line involved to cover for you failing to deliver on expiry.

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