Borrowing and Lending Shares for Short Selling

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Shorting: Borrowing and Lending Shares

Q.: What short selling instruments are available?

A: Shorts include all kinds of derivatives some of which include buying a put, selling a call, or using CFDs or spread betting to go short via a proprietary contract. Note the latter may not, and very probably will not, include trading the underlying (one is only betting against an internet platform). All it means is that if the underlying security's price falls, regardless of the tool or strategy, you come out ahead.

Q.: How popular is short selling in practice?

A: Short selling is not very popular among individual investors for two reasons 1.) it is risky 2.) it so so unnatural for a personal investor to go short. In fact, less than 2% of New York Stock Exchange trades are short sales, and the figure is even lower on the Nasdaq stock market.

• In the first instance there are the active traders who buy and sell shares more frequently.
• Most of the short-sells are executed by hedge funds or a handful of high-risk unit trusts (mutual funds) that specialise in short positions.
• There are also the portfolio managers and private investors who need to hedge their trading portfolios in the short term with CFDs and other derivatives.

IG Group (which operates IG Markets and IG Index) when noting the introduction of by the UK FSA of the rules in relation to the shorting of certain financial stocks has commented that in the first quarter of the financial year (being the period 1 June 2008 to 31 August 2008), less than £150,000 of IG's total revenue of £53m resulted from clients shorting the 29 financial stocks which have been identified by the FSA. This low number reflects the long bias that clients have in single stock positions. Blimey! So during the best market opportunity in years to short banks, it seems the punters (using IG at least) missed out badly. Indeed, late last year, I recall IG Index saying about 95% of its client positions were betting prices would go up.

Q.: What are the limitations/restrictions on short selling?

A: To start with you need to have a margin account in order to sell shares short. A margin account allows the broker to extend credit to you.

There are various other restrictions on the size, price and types of stocks you are able to short-sell. For instance, many CFD brokers impose large margin requirements on clients who short stocks with a low market capitalisation or stocks which tend to experience wild swings. Before July 2007 the SEC also enforced an uptick rule requring every short sale transaction to be entered at a higher price to the previous trade (thus keeping short sellers from continuing to add downward pressure to stocks which are already experiencing share falls) - this rule has not been removed. Remember also that since you do not own the security you must pay the lender of the stock any dividends or rights declared during the holding period. This means that should the stock experience a 'split' during the course of your short, you'll owe twice the number of shares at half the price.

Lastly, in most cases you can hold a short for as long as you please, however in certain cases you may be forced to cover if the lender wants the stock back (which you borrowed). As a broker can't sell what they don't have so will either have to come up with new shares to borrow or you'll have to cover (aka as 'being called away). This is not to say that it happens oftens but you need to be aware of this possibility if you are short-selling a security.

Q.: What if a stock is listed that it cannot be short sold?

A: First, give a call to your broker; in quite a number of cases the provider can still allow you to take the position. However, in such cases you might be charged a daily borrowing fee (since the broker may incur higher costs) but at least you are able to take the deal. In practice, it is best to stick to very liquid stocks like FTSE 250 shares when short-selling. This will at least allow you to exit the position if the market moves against you.

Q.: I'm being charged a borrowing cost for my short position. What is that?

A: Betsson is a Swedish stock listed on the Stockholm exchange thus traded in SEK.

Note that when you open a short share CFD position, you may incur a 'borrowing charge' which will be subtracted from the relevant applicable annual interest rate. You will only incur a borrowing charge if your broker also incurs such a charge when they open a hedging trade in respect of the same share in the underlying market; and they usually pass the charge onto you with no mark up.

Note also that the interest charges and stock borrowing charges are two separate things and stock borrowing charges only apply to certain shares and at certain times. Whereas, adjustments to reflect the effect of interest are calculated daily and posted to your account daily i.e. the overnight funding charge applies in order to reflect the effect of interest. Interest on long positions is debited from a client's account; on short positions, there may be a credit or a debit depending on the respective annual interest rate. Effectively, due to the low annual interest rates, interest is currently debited by most brokers from a client's account regardless whether you are long or short. If the annual interest rate is 2.5% (the broker's interest rate) or more then you will be credited interest for short positions.

To determine whether a borrowing charge also applies, it is best to call or send an e-mail to your broker in advance of trading. The borrowing charge, and your ability to go short, can be changed at short notice.

Q.: Why do some companies or brokers impose borrowing costs on one stock and don't impose such a fee on others?

A: Please be advised that it is your CFD provider's brokers (whom your CFD provider opens the client's positions with) or the companies themselves that impose stock borrowing charges and the CFD provider has no influence on why and when these charges occur. However, if stock borrowing charges apply your CFD provider will then charge you accordingly to reflect this.

To explain: Whenever you go short you sell assets which have been 'borrowed' from a third party with the intention of buying identical assets back at a later date to return to the lender. Hence, the lender may or may not impose a borrowing charge. Note that it is up to the individual lenders to impose this charge and therefore this charge is up to their discretion.

Q.: Are there any differences in short selling between a Market Maker as opposed to a Direct Market Access Broker?

A: Yes, there can be differences. A market maker is able to allow you to short whichever stocks they please but most providers will want to offset their exposure. Most CFD market makers will hedge a certain percentage of client orders into the market but most of the times they will also be running their own 'book'. Any exposure not hedged will ultimately lie on their books and should the shares that your broker is unable to physically short-sell themselves keep falling, then their exposure will similarly increase. They could use the futures market to offset some of this exposure but this may not provide sufficient cover.

Q.: Why on earth would someone lend me shares which he paid good money for when your intention is to profit from the shares falling!!?

A: Traditionally fund managers and pension funds frequently lend shares to short-sellers. Not only that but very few institutions and large investors actually hold the share certificates and do all the paperwork for registration and dividends: shares are held by custodians, and stock-lending is a nice little fee-earner for them.

Part of the difficulty for the small private investor is that for a fund or similar to accumulate enough money to finance a pension the fund must also speculate. This may sound too simplistic to those-in-the-know, but if you own a share for which you paid, say, £4 then the only way to make money is to wait until someone will want to buy it off you for more than £4. By facilitating shorting, and presumably taking a cut of any profit or charging the borrower a fee, the lender gets to keep the share whilst participating in any fall in value which, after receiving the cut or fee, might compensate for any drop in value. In exchange, the shorter (the borrower of the share) gets to make a few bob if the sp falls as presumably the shorter expects it will.

In practice the whole transaction is done by means of a 'repurchase agreement' (or 'repo'). This means that you actually sell the shares to me for say $10,000, but at the same time we agree that I will sell you those shares back in, say, a week for $10,020 (regardless of what they are actually worth then). Effectively, you lend me the shares and I lend you $10,000 and you pay me $20 in interest, but in practice I am now the legal owner of the shares, so I can very easily sell them (no misleading the buyer there!). All I have to do is buy them back within a week's time to return them to you.

The fees for stock lending that custodians and their clients (i.e. the super funds) earn would, over all, add up to far more than the perceived damage that is done by shorting. So in effect the custodians lend shares because they are then able to charge interest.

Q.: Ok, but who is in practice lending me shares when I go short on a CFD trade?

A: Actually, when you borrow stocks to short you are borrowing them from your broker. They usually hold inventory for this very purpose. Otherwise, they can also get it from one of the firm's customers or even another brokerage firm or institution holding the stock.

Q.: Are underlying shares actually borrowed and sold if I create a short position with a CFD?

A: It depends upon the CFD provider. Remember a CFD is a private bet with your provider - they could be left out of pocket. As a result, the majority will not accept a CFD order unless they can cover their risk by executing a required covering trade in the market. E.g. if you wish to short a stock, but shares are not available, then they may not take your order.

Most providers will always cover. Some will use their discretion, based on the fact that n00bs usually lose (and their losses are a valuable income stream), and that very good traders tend to know something, so betting with the customer may also be profitable. A number of provider offer 'direct market access' contracts for differences - in these, you get access to live market data, and you place the hedging trade for them. Your position is taken at the exact cost of the hedging trade plus dealer's spread.

Q.: What's the logic of a broker paying interest if you go short if you still use margined trade with borrowed money?

A: Because you've 'sold' the instrument. Thus, in a way, they owe you money till you close the bet by 'buying' it back.

Q.: But where do brokers get the money to pay the interest on a short account if they don't have an opposing long position?

A: As the CFD broker has sold the stocks to go short they receive money from the buyer and the broker then has to borrow the stocks and pay a rate of interest for that, when Libor is higher the money paid to borrow the stock is less than the money received from having the cash to enable the broker to pay interest to the short party.

However, in practice knowing who pays financing to which party isn't really going to help you be more successful so it makes more sense to accept the fact that you get charged interest on long positions and receive some interest credit on short positions (the level of interest on short positions is dependent on Libor which I believe is zero at the present time).

Q.: But you should have to buy something before you earn the privilege of being allowed to sell it!

A: The entire economy is built on borrowing assets and then selling them so it is hard to make this argument consistently unless you are also going to condemn the practice of borrowing to buy a house. Although this is not far from the position that proponents of Sharia law would adopt, condemning much home mortgage lending as usury.

Tesco and the like, do this all the time. It's the business model. They take delivery of products, on account, and sell to the customer, Take the money from the customers' bank immediately and pay the supplier 30, 60, 90 or 180 days later. They hold the risk of not selling, i.e. breakages, stolen or holding Easter eggs in June.

I would say that if this was not employed the cost of shopping would go higher. Pension funds loan shares for a return - the current share price in not an issue to them for the loan term, in normal circumstances, this is designed to increases the pension fund value most people will/do rely on.

Let's take the car example: a car broker (i.e. Bill and Ben the Car Shop Men) take an order on a Porsche 911. They don't own the car yet, but they take a deposit anyway. Then, they phone up Porsche, and buy the car. They always intend to deliver the car, and if Porsche changes its prices they have to pay the difference. The car buyer goes away happy, the broker goes away happy, and Porsche is happy. If the car broker didn't short Porsches, the car buyer would go to another garage that does short Porsches.

Taking the house example: A property company is building houses. Rather than fund the entire deal themselves, they invite people to look around an example house, and the buyers like what they see. They agree to buy the property and fork out a deposit. The deposit allows the property company to borrow money from the bank, and then build the house. If the cost of building the house goes up, the property company normally has to take the loss on the chin. If the property company didn't short-sell houses, they couldn't build as many, and the price of houses would be much higher.

Short selling is a normal feature of a working market. I can find examples of all kinds of markets where it occurs - from your yearly Christmas turkey to groceries from Tesco's direct, from luxury yachts to shoes.

 ...Continues here - Preventing your Shares Holdings from being Shorted