Short Sell - Here we do not own the stock, but we borrow it from another investor, sell it to a third party, and, in theory, receive the proceeds. We are obligated to pass on to the lender of the stock any dividends declared on the stock and also to pay to the lender the market price of the stock if he himself should decide to sell. When we short sell, we believe that the stock will decline in value thus enabling us to buy it back at a low price later on to make up our obligations to the lender. We are expecting a bearish market for the stock. It is also said that we are short the stock.

When a short sale is executed, the brokerage firm must borrow the shorted security from its own inventory or that of another institution. The borrowed security is then delivered to the purchaser on the other side of the short-sale. The purchaser receives dividends paid out by the corporation. The short-seller must pay out any dividends that are declared by the firm to the original owner from whom the security was borrowed, during the period in which the short-sale is outstanding. To close out the short sale, the short seller must buy the stock in order “return” the security originally borrowed. Note that borrowing fees can be significant for “hard-to-borrow” securities because these securities can have high demand, due to a high level of short-selling (e.g., Netscape immediately after it went public).

In modeling finance problems we often assume that the investor receives the full proceeds of a short-sale. There are a number of practical mechanics which limit the investor’s ability to access these funds. The proceeds from a short sale are usually held by an investor’s brokerage firm as collateral. The investor usually does not receive the interest from the short sale proceeds, and will likely have to meet a margin requirement. In practice, short sales require a cash outlay. They do not provide a cash inflow.