Did you know that in the world of trading you can sell a security before you own it? \\
As surprising as that sounds to someone who’s new to the world of the stock market, it is, in fact, a real practice and it’s called short selling. Now, because you don’t own this security you’d typically borrow it from a broker/dealer before you short sell it on the market.
Which brings in the practice of borrowing.
We’ll be further delving into these two practices.
Let’s begin with short selling. Short selling, in more detail, is when you sell a stock for a certain price, although at the time of sale you don’t own that stock. The money you get from that sale goes into your account and then you buy the actual stock, hopefully for a lower price than what you sold it for.
The money you have leftover from the initial sale is your profit, minus commission of course.
Now that explanation is if a short sale goes all according to plan. On the flip side, you can sell a stock for a particular price, that money from the sale goes into your account and then when you go to buy the actual stock, the price of that stock has gone up instead of down and now you end up losing money.
Instead of profit, you end up with a loss on top of the commission that you owe. This risk is well known when it comes to short selling and it’s why short selling is typically not recommended for first-time or ill-informed investors. A short sale gone wrong can wipe out a lot of money and without emergency funds on hand to cover the losses, it can be catastrophic.
Now, as mentioned before, if the investor does not currently own the stock, they will borrow the stock from a broker/dealer. Once the investor buys the stock on the market, they return that stock to the broker. With this process comes a fee that is to be paid to the lender, this is called a borrowing cost.
Something to note is that there are restrictions placed on short sales depending on the market that the sale is currently being done in. So in the U.S., a stock is only eligible for short sale if the last price movement is positive. This is known as the uptick rule and is put in place to limit the volatility of fluctuations in the market. Another of these rules prevents brokers/dealers from investing the proceeds from short sales in other positions.
This rule limits the number of leverage brokers can create.
If we take a look at UK restrictions, we’ll see that in place of the uptick rule, leverage is limited using the capital adequacy norms. This is the ratio of a bank’s capital in relation to its risk-weighted assets and current liabilities. You’ll sometimes see this abbreviated as CAR. What this does is protect depositors and promote the stability and efficiency of financial systems around the world.
Similar to margin trading, an investor is required to deposit a margin in case of short selling also. This is to protect the broker/dealer from having to cover losses in the event that the stock rises, instead of falls, as the investor predicted. So, be well versed and properly informed the restrictions of the market your working in to avoid further risk than is already present in short selling.
Now that we understand short selling better, we can more delve into borrowing. Like I said before, when short selling a stock an investor will borrow that particular stock from a broker/dealer. The broker lends the stock from the securities that the broker holds or is in their custody on behalf of their clients. Some large investors with securities of their own will lend stock directly in the market. To break it down further let’s take a look at the two types of loans that there are.
There are Call Loans, which are loans that the lender can terminate at any time. The lender can also call for this type of loan to be repaid at any time. This is similar to a callable bond, with the difference being that the lender has the right to call in the loan repayment instead of the borrower. This is the most common loan.
The other type of loan is Term Loans. These are defined as loans that are provided for a specified period. For example, if it was decided that the period that a lender loaned a stock out for a month. The term, as referred to in the title, is the amount of time that a lender is allowing their stock to be borrowed.
Both of these loans are common in bank practices as well as in terms of stock market dealings, the only difference being that when used in relation to investing, you’re loaning out stocks instead of money.
Here’s a bit of additional information to keep in mind…
The typical fee for a stock loan is 0.30% per annum. Per annum is an accounting term that means yearly or annually. So if we calculate that out, it would be 0.30 x 12 months, which amounts to 3.6%. In the case of short supply, this fee can skyrocket up to 20-30% per annum. If we were to calculate that out, we’re looking at 240-360% per annum. So cross your fingers and hope that investors are never short on a particular stock.
Another thing to keep in mind is that, even though the stock is borrowed by the investor, the dividends still belong to the lender. So, while returning the stock, the investor has to pay the loan fee along with any dividends received while they were in possession of the stock. So always make sure to factor in the loan fee along with any dividends that may be received when weighing out whether or not to short sell.