Short Selling Mechanics and Locate Requirements

A short sale requires a locate under Regulation SHO before the order is placed, and the borrow fee on a hard-to-borrow name can dominate the trade.

Short selling requires borrowing shares before selling them, and the mechanics of that borrow, alongside the direction of the trade, determine whether a short position is economically viable. A short seller must locate a lender, post collateral against the loan, and pay a fee that can swing from close to nothing on an easily borrowed stock to a large ongoing cost on a stock that is scarce to borrow.

To sell a stock short, a trader borrows shares from a lender, typically a custodian bank, a broker-dealer's own inventory, or another institutional holder willing to lend, and sells those borrowed shares into the market. The short seller eventually buys the shares back to return them to the lender, and the trade profits if the repurchase price is lower than the original sale price, after accounting for any borrow costs paid along the way.

The lender retains economic exposure to dividends and voting rights through a manufactured payment arrangement, meaning a short seller who holds a position through an ex-dividend date has to pay the lender an amount equal to the dividend out of pocket, on top of whatever borrow fee is already accruing on the loan.

Rule 203 of Regulation SHO requires a broker to have reasonable grounds to believe a security can be borrowed and delivered before accepting a short sale order, a step known as the locate. This requirement exists specifically to prevent naked short selling, where a trader sells shares short without ever confirming a borrow exists, which can lead to settlement failures if the shares are never actually delivered.

A locate is not the same as an actual, executed borrow. It is a good-faith reservation that shares are available, and the broker only converts that reservation into a firm borrow once the short sale actually executes, which means a trading desk can lose a locate to another market participant if it hesitates too long before placing the order.