Short-selling and dividends

Here’s a downside you may not have thought of

Question: I shorted a large amount of a dividend-paying stock and was surprised that its latest quarterly dividend was deducted from my brokerage account. Why did I have to pay it?

Answer: There are several downsides to short-selling. You have unlimited loss potential, the market has an inherent positive bias over the long run, you’ll probably have to pay a fee for borrowing the shares, and yes, you are responsible for paying any dividends issued by the stock while you’re short.

Here’s why. Consider the basic mechanism of how short-selling works.

When you short a stock, you’re borrowing shares from someone else (typically your brokerage firm) and selling them on the open market. Your hope is that the stock’s price goes down, so you can repurchase and return the borrowed shares for less than you sold them for.

However, in the meantime, whoever you borrowed the shares from still technically owns them. And if there’s a dividend that is scheduled to be paid out, they’re entitled to it. Since their shares have been sold to a third party, the short-seller is responsible for making the payment, if the short position exists as the stock goes ex-dividend.

As an example, let’s use AT&T, which pays a 50-cent quarterly dividend. If you short 1,000 shares of AT&T and keep the position open through the next exdividend date, you’ll owe your broker $500 on top of any other expenses.

Matthew Frankel, CFP, owns shares of AT&T. The Motley Fool has no position in any of the stocks mentioned.