What Is a Rebate?
In stock trading, a rebate occurs when a short seller has taken a short position in a stock that then pays a dividend before the settlement date. The rebate is the dividend that the short seller is required to pay to the owner of the stock.
In short selling, the trader borrows the stock and then sells it, expecting to buy it back and return it to the lender at the settlement date. Essentially, the stock owner is the lender and the short seller is the borrower.
The goal of selling short is to profit from a price decline by buying the stock back at a lower price. Selling short exposes the seller to unlimited risk since the price of the shares that must be purchased can increase by an unlimited amount.
How a Rebate Works
If the borrowed stock pays dividends, the borrower must pay those dividends to the lender. Generally, large institutions, market-makers, and traders with broker/dealer status are lenders to short-sellers and beneficiaries of rebates. It is uncommon for an individual borrower to qualify as a lender as their holdings are too small.
Let’s say that a trader wants to short 1,000 shares of a stock priced at $100. The trader borrows the shares, with a settlement date in 90 days, and sells them. After 30 days, the stock pays a dividend of 2%. The short-seller must pay the lender of the stock $2,000 (2% x 1,000 x 100).
Short Sale Rebates and Margin Accounts
If you are going to short stocks, you will be required to open up a margin account with a brokerage, as required by Regulation T of the Federal Reserve. A margin account is created for a customer who borrows cash to invest in a long position or shares to create a short position. The margin requirements act as a form of collateral that ensures the shares will be returned in the future.
The Federal Reserve requires the investor to deposit 150% of the value of the short sale trade. Since short sellers are exposed to unlimited losses, a substantial deposit is required to protect the brokerage firm from potential losses in a customer’s account.
If the price of the security increases, the short seller will be asked to deposit additional amounts to protect against larger losses. If the price continues to rise on a position, causing a larger loss, and the borrower is unable to deposit more capital, the short position will be liquidated. The borrower is liable for all losses, even if those losses are greater than the capital in the account.