Short Sale

Ottilie Brandt believes Fenwick Rail Supply is overvalued at $80 and sells 100 shares short in her margin account. While the position is open the company pays a $1.20 per share quarterly dividend. Which statement about her position is correct?

1. A.She will receive the $1.20 per share dividend, because she was the seller of record on the payment date.Incorrect and backwards. She sold borrowed shares, so she must PAY the dividend over to the lender of those shares.
2. B.She must pay the dividend to the lender of the shares, her maximum gain is limited to the $8,000 of proceeds, and her potential loss is theoretically unlimited.Correct. The dividend is an out-of-pocket cost, the best case is the stock falling to zero, and there is no ceiling on how far it can rise.
3. C.Her maximum loss is limited to the $8,000 of proceeds and her potential gain is unlimited.Incorrect and exactly inverted. That is the profile of a LONG position, not a short sale.
4. D.The position may be held in a cash account, because she received cash proceeds when the shares were sold.Incorrect. A short sale involves borrowed securities and must be effected in a margin account.

Why: A short seller borrows shares, sells them into the market, and must eventually buy them back to return them. Three consequences follow. First, the borrowed shares still belong to someone, so the short seller must pay the lender any dividends declared while the position is open; those payments are an out-of-pocket cost, not income. Second, the risk profile is asymmetric and unfavourable: the maximum gain is capped, because the best possible outcome is that the stock falls to zero and she keeps the $8,000 of proceeds, whereas the potential loss is theoretically unlimited, because there is no ceiling on how high the price can rise before she must cover. Third, short sales must be effected in a MARGIN account, since the position involves borrowed securities. A further tax point worth knowing is that gains on short sales are treated as short-term capital gains regardless of how long the position was held.

Before executing a short sale, a firm must:

1. A.Wait for an uptick onlyA tick test is a condition on the price at which a short sale may print, not a condition on securing the shares. It is not the general pre-trade obligation, and in any case it addresses a different concern from the one the locate requirement was written to solve.
2. B.Own the shares alreadyIf the customer already owned the shares the trade would be a long sale, not a short sale. Selling stock one does not own is the defining feature here, and that is precisely why arrangements to borrow must be made.
3. C.Locate/borrow the shares to deliverCorrect - locate before shorting.
4. D.Get SEC approvalThe SEC writes rules; it does not sign off on individual orders. The duty falls on the firm, which must satisfy itself before execution that the security can be borrowed and delivered.

Why: Under the locate requirement, the firm must have reasonable grounds to believe the security can be borrowed and delivered.

A firm's order marking system offers more than just 'long' and 'short' designations for equity sale orders. What is the third marking category available for certain short sale orders?

1. A.'Short exempt,' a designation used for short sale orders that qualify for an exception to the short sale price test.Correct. 'Short exempt' is the third marking category, used for orders qualifying for the price test exception.
2. B.'Unassigned,' a placeholder designation used until the trader determines ownership status later in the trading day.Wrong. There is no such placeholder marking category; ownership must be determined at order entry.
3. C.'Riskless principal,' a designation reserved for orders the firm fills from its own inventory rather than in the market.Wrong. Riskless principal describes a trading capacity, not a long/short/short-exempt marking category.
4. D.'Pending locate,' a designation used for short orders awaiting stock loan desk confirmation before execution is permitted.Wrong. There is no such marking category; a locate must be obtained before the order is accepted, not marked as pending.

Why: Order marking for equity sales is not limited to a simple long-or-short binary. 'Short exempt' is a third category used specifically for short sale orders that qualify for an exception to the short sale price test, allowing those orders to be distinguished operationally from ordinary short sales that remain fully subject to the price restriction.

A representative enters a short sale order for a customer without the firm having reasonable grounds to believe the security can be borrowed for delivery. What Regulation SHO requirement does this implicate?

1. A.This implicates Rule 203's locate requirement, and the principal must ensure a proper locate is obtained before the order is acceptedCorrect. Rule 203 requires reasonable grounds to believe the security can be borrowed before accepting or effecting a short sale, not merely by settlement.
2. B.Nothing, since locate requirements apply only to market maker short salesWrong. The locate requirement is not limited to market maker transactions; it generally applies to short sale orders broadly, subject to specific exceptions.
3. C.Nothing, as long as the security is not on a threshold securities listWrong. The general locate requirement under Rule 203 is not limited only to securities on a threshold list; that list relates to additional close-out requirements.
4. D.Nothing, since the borrow only needs to be arranged before settlement date, not before the order is acceptedWrong. Reg SHO's locate requirement generally applies before the short sale order is accepted or effected, not merely by settlement.

Why: Rule 203 of Regulation SHO generally requires a firm to have reasonable grounds to believe a security can be borrowed and delivered by settlement date before accepting or effecting a short sale order -- the "locate" requirement. The principal must ensure this locate is obtained before the order is accepted, not after.